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
IRA inheritors may lose a lot to taxes
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.)
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.
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
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.
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.
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.
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)
|(2) Estate tax on inherited IRA (46% of $500,000)
|(3) Income tax deduction for estate tax, permitted under I.R.C. Sec. 691(c) (the "IRD deduction") before the 2% "haircut";
|(4) IRD deduction after the 2% "haircut"((3)minus $9,990)
|(5) Tax savings associated with Sec. 691(c) deduction (35% of (4))
|(6) Net value of transfer (Subtract (1) and (2) from $500,000; then add (5))
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.
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
Fidelity Charitable Services is a registered service mark of FMR Corp.