July 2006

Clients Should Plan to Donate Retirement Assets

Legislation surrounding the donation of Individual Retirement Accounts (IRAs) and qualified retirement plans to charity has been discussed frequently during the past few years but laws have not yet been enacted. Many clients who would like to donate IRAs or qualified retirement plans to charity are still hoping for a law that would permit them to do so while they are alive without having to pay income tax on the amount distributed. Meanwhile these clients can provide an alternative route to apply the funds to a philanthropic use through their estate plans. Tax incentives for these transfers do not require any action by Congress—they already exist. But implementing them does require some advance planning.

IRA inheritors may lose a lot to taxes

Together estate taxes and income taxes substantially diminish an inheritance from a traditional IRA, 401(k) or 403(b). (Because the same rules apply to all retirement plans in this context, we use the shorthand "IRA" in discussing the subject.)

  • Withdrawals from these plans are considered "income in respect of a decedent" or IRD, meaning income that was not taxed before a person's death.
  • That means someone—typically the person or entity withdrawing money from the IRA—must ultimately pay income tax on it.
  • In estates worth more than $2 million, there is also an estate tax of 46% on the IRA inheritance.1

There are ways for clients to avoid the often heavy taxation on IRD assets, but they must plan ahead.

Planning wisely

By leaving an IRA to charity, rather than to heirs, clients can eliminate income taxes on withdrawals and achieve estate tax savings while benefiting the charities they care about most.

  • A charity, which is tax-exempt, can take out the funds from an IRA without paying tax on the withdrawals.
  • The estate can take a charitable deduction for the amount left to charity. For example, when a $1 million IRA goes to charity and the total estate is worth $8 million, there's a $1 million estate tax deduction and the estate tax is applicable only on the remaining $7 million.

Case study

Your client, a 75-year-old widow with two grandchildren, has a net worth of $8 million. Her assets include: a $1 million IRA, real estate valued at $3 million, and long-term appreciated securities with a current market value of $4 million. She asks you to compare the tax consequences of leaving her entire IRA to charity or dividing it between her two grandchildren in equal shares.

Your answer will depend on how quickly the grandchildren withdraw funds from the IRA, but base your calculations on the worse case scenario: that the client dies in 2006 with an estate worth $8 million and that the grandchildren withdraw all the IRA assets this year.

The first $2 million of the client's estate would be exempt from tax. After that, a 46% estate tax would apply.

Each grandchild has an adjusted gross income (AGI) of $650,000, including the $500,000 IRA withdrawal. Under Internal Revenue Code Sec. 691(c), they can take an itemized deduction on their income tax return for the estate tax attributable to the inherited IRA, and use it to offset the income tax on funds withdrawn from that IRA. However, this "IRD deduction" does not totally defray the estate tax. That is because the deduction is reduced by 2% of the amount by which the grandchild's AGI exceeds a government-set threshold, which varies each year (for 2006 it is $150,500 for singles and married taxpayers filing joint returns, and $75,250 for married people filing separately). In the case study below, this "haircut" is $9,990.

The following chart shows how federal taxes reduce the inheritance, and compares that result with leaving the entire IRA to charity.

  IRA to grandchild IRA to charity
(1) Income tax on IRA withdrawal (35% of $500,000) $175,000 0
(2) Estate tax on inherited IRA (46% of $500,000) $230,000 0
(3) Income tax deduction for estate tax, permitted under I.R.C. Sec. 691(c) (the "IRD deduction") before the 2% "haircut"; $230,000 n/a
(4) IRD deduction after the 2% "haircut"((3)minus $9,990) $220,010 n/a
(5) Tax savings associated with Sec. 691(c) deduction (35% of (4)) $77,003.50 n/a
(6) Net value of transfer (Subtract (1) and (2) from $500,000; then add (5)) $172,003.50 $1 million

Conclusion: Given a choice about how to divide up the assets in her estate, this client is better off giving her IRA to charity, and leaving her children and grandchildren other property.

  • Estate taxes, together with income tax on the IRD, would consume $327,996.50 or 65% of each child's inheritance.
  • The result of naming a charity, rather than the two grandchildren, as the IRA beneficiary is that $655,993 ($327,996.50 times two) that otherwise would have gone to taxes would go to charity instead.
  • By leaving other long-term appreciated property, like stock and real estate to her heirs, the client would enable them to get a stepped up basis at her death,2 reducing the capital gains tax they would have to pay on the assets if they decided to sell them.

How to name a charity as IRA beneficiary

Since money in a retirement account passes outside of a person's will, it's necessary to spell out the client's wishes to leave it to a charity on the IRA beneficiary designation form. The options include:
  • Making the charity a 100% beneficiary of the IRA
  • Indicating that the charity is a beneficiary of a certain percentage of the IRA, and that the rest should go to individual beneficiaries in particular shares
  • Specifying that the family can disclaim an inherited IRA, if they choose, and have it go to the charity

Advantages of making a donor-advised fund an IRA beneficiary

Although it's possible to designate any organization that would result in a charitable deduction from income tax, naming a public charity with a donor-advised fund program, such as the Fidelity Charitable Gift FundSM, as an IRA beneficiary gives clients and heirs more flexibility.
  • When clients are not sure which causes they ultimately want to support after death, instead of naming charitable beneficiaries to their account, they may choose to name an individual successor(s) to the Giving Account.
  • Upon the donor's death, the charity that operates the donor-advised fund program establishes a Giving Account in the individual successor(s) name which is then funded with the IRA. The donor's successor can then make grant recommendations to the charities they would like to support.
  • The donor can also specify that the IRA be divided into multiple donor-advised fund accounts, with the individual successors named to their own accounts.

Talk with clients today about the tax benefits of naming a charity as an IRA or non-qualified plan beneficiary. For more information, please contact a Fidelity Charitable Services representative at 1-800-280-6357 or visit www.fidelitycharitableservices.com.

1This rate applies to estates of people dying in 2006. The rate drops to 45% for those who die between 2007 and 2009.

2Under IRC Sec. 1014, someone who inherits appreciated property can generally use as its income tax basis the fair market value of the property on the date of the decedent's death.

The Fidelity Charitable Gift Fund ("Gift Fund") is an independent public charity with a donor advised fund program. Various Fidelity companies provide non-discretionary investment management and administrative services to the Gift Fund. Charitable Gift Fund is a service mark and Giving Account is a registered service mark of the Trustees of the Fidelity Investments Charitable Gift Fund. Fidelity and Fidelity Investments are registered service marks of FMR Corp., used by the Gift Fund under license.

Fidelity Charitable Services is a registered service mark of FMR Corp.