Tax Planning for Charitable Gifts with Retirement Assets

April 23, 2002

Due to their dramatic increase in value, retirement assets have become an increasingly important aspect of estate planning. For those considering making charitable gifts with retirement assets, proper tax planning is crucial. Under current tax law, lifetime transfers of retirement assets to charity produce only minimal tax advantages. However, transfers at death may result in significant tax advantages.

For purposes of this article, “retirement assets” or “plan” include: traditional (vs. Roth) Individual Retirement Accounts, SEPs and SIMPLE plans; pension, profit sharing, 401(k), Keogh and stock bonus plans; and 403(b) tax sheltered annuity plans.

Retirement assets are subject to federal income taxation when distributed either during the life of the participant (the person/employee whose plan we are considering) or following the participant’s death. Retirement assets are also subject to federal estate taxation at the participant’s death and Pennsylvania inheritance taxation (but not income taxation) if the participant was over the age of 59 1 /2 at death.

Charities generally do not pay income taxes; therefore, a charity would not have to pay federal income tax upon receiving a distribution of retirement assets as would an individual. Because of the federal and Pennsylvania death tax charitable deduction, retirement assets distributed to charity also do not incur federal estate/ Pennsylvania inheritance tax.

A participant’s lifetime transfer of retirement assets to charity results in a charitable income tax deduction, but also requires inclusion of the distribution in the participant’s income, thus eliminating most of the tax advantage. Distributing retirement assets to charity at death is often the most tax-effective way to fund a charitable transfer because the transfer will be free of both federal income and estate/inheritance taxation.

Example: John Smith wants to leave half of his $1.4 million estate to charity and half to his daughter, Mary. His assets consist of a $700,000 IRA and $700,000 in stocks and bonds. Mary is in the 39.6% income tax bracket. If John leaves half of each asset to the two beneficiaries, they would receive the following:
                                           Charity                Daughter
Stocks and bonds                $350,000                $350,000
IRA                                    350,000                350,000
Gross Amount                       700,000                  700,000
Less income tax on ½ IRA (0)                        (138,600)
Net bequest                       $700,000                $561,400

If John’s estate plan instead provided for the IRA to pass exclusively to charity with the other assets going to Mary, the bequests would be taxed as follows:
                                          Charity                   Daughter
Stocks and bonds                 $0                        $700,000
IRA                                       700,000                  0
Gross Amount                        700,000               700,000
Less income tax on ½ IRA   (0)                         (0)
Net bequest                         $700,000                $700,000

Avoid naming a charity as one of several plan beneficiaries or potential beneficiaries along with individuals, since doing so results in reduced deferral of income taxes, a larger minimum required distribution and a required payout of the entire plan balance within five years following death of the participant. Instead, create a separate, segregated account of retirement assets that will pass to the charity.

Another possibility is to name a trusted individual as primary beneficiary of the plan with the charity as contingent beneficiary. This results in smaller minimum required distributions during the participant’s lifetime, resulting in a larger amount of plan assets remaining at the participant’s death. If the primary beneficiary does not survive the participant, the plan assets pass to the charity. If the primary beneficiary survives the participant, he or she can disclaim some or all of the plan assets, allowing the disclaimed amount to pass to the charity as contingent beneficiary.

Use of charitable gifts can “rescue” a plan in which the participant is over age 70 1 /2 , is required to recalculate his life expectancy and has failed to name a designated beneficiary. Without intervention, upon the participant’s death the entire plan balance must be distributed within one year of death and income taxes paid by the recipient. However, if the participant names a charitable remainder trust as beneficiary and designates individual beneficiaries as life annuitants of the trust, income taxation of the retirement assets can be significantly deferred.

For those with philanthropic goals, proper planning with retirement assets requires careful analysis to obtain optimal income and death tax benefits. We would be pleased to assist you in meeting these goals.

For more information, please contact hjohnston@cohenlaw.com.