Tax-Smart Strategy: Leaving IRA Money to Charity

These days, many people have a large percentage of their wealth in the form of traditional IRA accounts. In most cases, this is because significant distributions have been rolled over tax-free from qualified retirement plans to these IRAs. A lot of people also have charitable intentions. If this sounds familiar, there’s a tax-saving strategy you should know about:

Consider designating your favorite charity or charities as beneficiaries of all or a portion of your IRAs. Then leave other assets to family members or other heirs.

Without Planning, Double or Even Triple Taxation is Possible

Take a look at how it works:

• • • First, your traditional IRA account is included in your estate for federal estate tax purposes when you die. That’s tax number one.
    • Next, the taxable portion of the IRA balance (which is often the entire amount) is counted again as “income in respect of a decedent” (IRD) for federal income tax purposes. That means federal income tax will be owed when IRA withdrawals are taken by your estate or your heirs. That’s tax number two.
    • To make matters even worse, state income tax may be due as well. If so, that’s tax number three.

After all these taxes have been paid, your heirs may receive only a very small fraction of your IRA money while tax collectors get the lion’s share.

Take a look at how it works:

• • • First, your traditional IRA account is included in your estate for federal estate tax purposes when you die. That’s tax number one.
    • Next, the taxable portion of the IRA balance (which is often the entire amount) is counted again as “income in respect of a decedent” (IRD) for federal income tax purposes. That means federal income tax will be owed when IRA withdrawals are taken by your estate or your heirs. That’s tax number two.
    • To make matters even worse, state income tax may be due as well. If so, that’s tax number three.

After all these taxes have been paid, your heirs may receive only a very small fraction of your IRA money while tax collectors get the lion’s share.

A Charity as IRA Beneficiary is the Cure

A tax-smart solution is to leave some or all of your IRA money to charitable beneficiaries while leaving everything else to other heirs you choose. The net result will be more after-tax cash for them. At the same time, you can satisfy charitable inclinations after you die. Sound good? Here are the details.

By naming one or more tax-exempt charitable organizations as beneficiaries of your IRA, you leave that money to the charities after your death. Under our current federal tax system, that is the only way to leave IRA balances directly to charity, although proposals have been made to change that. Alternatively you could take money out of your IRAs while you are still alive, pay the resulting income tax, and then give cash to the charities. Your contributions may be fully deductible for income tax purposes, although income-based restrictions might limit your charitable write-offs. In that case, you may have to claim your charitable deductions over several years. Depending on your taxable income, you may never be able to completely write off large donations. As you can see, this is an inefficient way to satisfy your charitable desires.

On the other hand, leaving IRA money directly to charities upon your death by designating them as account beneficiaries is very tax-efficient. First, an IRA balance left to charity avoids the federal estate tax, since it is removed from your estate for federal estate tax purposes. Second, there’s no federal income tax due on the IRA money (the IRD rules don’t apply). There’s no state income tax either. Finally, no income taxes are due when your favorite tax-exempt charities take their withdrawals from the IRAs. So you avoid double or triple taxation in a simple way.

Strategies for Your Loved Ones

If you are planning to make bequests to your loved ones, you can leave gifts of assets that are eligible for the federal income tax basis “step-up” to fair market value, as of the date of your death. These include common stocks and mutual fund shares held in taxable investment accounts, ownership interests in your small business, real estate, and just about anything else that qualifies for capital gain treatment when it is sold. Thanks to the basis step-up break, these assets can be sold by your heirs with little or no income tax (only post-death appreciation would be taxed). So there are no double taxation worries. However, they will be included in your estate for federal estate tax purposes, assuming your estate is taxable.

When all is said and done, this strategy allows you to leave more to your favorite charities, more to your loved ones, and less to the tax collector.

You can generally take the same steps with other types of tax-deferred retirement plan accounts as long as the accounts have specific balances. These include 401(k), corporate profit-sharing, SEP, and Keogh retirement accounts. If you’re married, however, state law may require you to obtain your spouse’s permission to name charities as beneficiaries of these accounts.

Conclusion: Designating your favorite charity as a beneficiary of your traditional IRA (and other tax-deferred retirement accounts, if your spouse approves) can be a tax-smart maneuver. With advance planning and the federal estate tax exemption, you have much more opportunity to minimize both federal and applicable state income and estate taxes. Contact your tax advisor if you have questions or want additional information.

Don’t Leave Roth IRA Balances to Charity

Naming a charity as the beneficiary of your Roth IRA is generally not advisable. Instead, you should leave Roth balances to your loved ones by designating them as the account beneficiaries. Here’s why: As long as your Roth IRA has been open for more than five years before withdrawals are taken by your heirs, all their withdrawals will be federal-income-tax-free.

But if you leave Roth IRA money to charity, this valuable tax break is completely wasted.

Remember: the required five-year period before federal-income-tax-free withdrawals can be taken starts on January 1st of the year for which you made the initial contribution to your Roth IRA. This includes contributions made by converting traditional IRA balances to Roth status.

For example, let’s say you made your initial Roth IRA contribution for the 2018 tax year on April 15th of 2019. You nevertheless start counting on January 1, 2018 for purposes of meeting the five-year rule.