Doing Right by Doing Good: Giving IRAs to Charity
By Stephen P. MagowanThe growth of the number and size of individual retirement accounts (IRAs) is well documented. An IRA often represents the single most valuable asset in a person's estate, particularly for doctors, accountants, lawyers and other professionals who frequently have IRAs with $1-2 million in assets. Unfortunately, from a tax perspective, an IRA is not a good asset to leave children and grand-children because: ù as an item of income in respect of a decedent (IRD), the IRA is sub- ject to both death taxes and income taxes (with a federal income tax deduction for federal estate tax paid); and ù if the IRA is substantial, part may be subject to the 15% excise tax on excess retirement accumulations under Code 4980A(d).
These taxes will often reduce a large IRA accumulation to 25% of its pre-death value. The heavy tax burden on IRAs has led to some predictable results. For instance, in recent years, insurance companies and agents have encouraged retirees to draw down IRAs more rapidly than the minimum distribution rules require and use the excess amount to purchase life insurance. An irrevocable life insurance trust typically holds the policy to ensure that its proceeds pass to the insured's beneficiaries free of estate tax. Those who market this approach often warn their clients that nearly all of the client's IRA will be wasted on taxes after death.
Although clients with large IRAs should always consider the use of life insurance as an IRA substitute, the technique has numerous drawbacks. First, the cash value of the policy in the trust must be kept out of the insured's hands if the policy proceeds are to escape estate taxation. Second, the insured will probably spend a significant amount on annual premiums, which will be wasted if the insured decides to abandon the policy because a typical policy will not generate much cash value in its early years.
The typical estate planning client considering a proposal to withdraw IRA funds to purchase life insurance often comes to a lawyer with one specific question: are there other options? This article suggests that lawyers should discuss with these (and other) clients the idea of naming charities or charitable remainder trusts (CRTs) as IRA beneficiaries. This article is intended primarily to serve as a checklist, not an in-depth review, of Code 401(a)(9) and the related proposed regulations and assumes familiarity with those rules and the rules governing CRTs. Many of the ideas described below will work equally well for defined contribution plans, including Code 401(k) plans and certain Code 403(b) plans, although these plans are not discussed. Defined benefit plans, by contrast, generally present too many problems to profit from these techniques.
Why Consider a Charity or CRT as Beneficiary?
There are many reasons for a client to name a charity or CRT as beneficiary or alternate beneficiary of an IRA or an IRA subaccount. First, using the IRA for charitable gifts may simply make sense in the context of the estate plan as a whole. Second, the gift to charity can reduce the estate tax immediately payable and the income tax that would be payable as the IRA assets are distributed. Under the IRD rules of Code 691(c), IRA distributions after an owner's death are subject to income tax, with a deduction for the incremental estate tax paid on the IRA. Charities and CRTs, however, as tax-exempt entities, are not subject to income tax on items of IRD they receive. Third, if a client uses a CRT, he or she can provide an income stream to his or her loved ones and also obtain the benefit of an estate tax charitable deduction.
A simple example may be helpful. Assume Mrs. Able walks into a lawyer's office and tells the lawyer that she is a widow in poor health. She owns $600,000 worth of securities and a $600,000 IRA. She has one child to whom she would like to leave $600,000. She would also like to leave $600,000 to Baker University, her alma mater. How should the lawyer advise Mrs. Able to fund her gifts?
In general, the lawyer should advise Mrs. Able to leave the IRA to Baker and give the remaining assets to her child. Why? Baker will not pay any income tax on the IRA because Baker is tax-exempt. Mrs. Able's estate will be entitled to an estate tax charitable deduction for the full amount of the IRA. Mrs. Able's remaining assets will pass to her child without estate tax and the child will receive a new basis in the assets. The child may then sell the assets and recognize little or no capital gain.
If the child receives the IRA, the child will pay income tax as he or she draws down the IRA. Because of the heavy income and death tax burden on the IRA (assuming no 15% excess accumulation tax is payable), every estate tax charitable deduction dollar only costs the child approximately 25-45 cents of after-tax estate dollars, depending on applicable state income tax rates.
Which Clients Will Benefit?
Before determining whether naming a charity or a CRT as an IRA beneficiary makes sense for the client, the lawyer must review the client's whole estate picture to determine whether an IRA-to-charity technique makes sense. Typically, the technique works well when one or more of the following factors are present:
- the client has no surviving spouse or is unlikely to have one because the spouse has a terminal illness;
- the client has a spouse who owns a significant IRA of his or her own;
- the client has loved ones whom the client would like to benefit from the IRA, but the client did not name any or all of them as beneficiaries of the IRA before the client's required beginning date (RBD);
- the client would like children or grandchildren to benefit from the IRA and is charitably inclined but has no other assets to leave to charity;
- the client and his or her spouse have no need to draw down the IRA for living expenses; and
- the client is charitably inclined and is indifferent as to which assets in his or her estate will go to charity.
If any of these factors are present, the lawyer should consider various IRA-to-charity techniques. The lawyer, of course, must understand the key rules governing IRAs, in particular the minimum distribution rules and the excess accumulation tax. With this foundation, the lawyer can lead the client through the analysis of whether contributing the IRA to charity makes sense.
Pre-RBD or Post-RBD?
When it comes to IRAs, there are two classes of clients: those who show up at their lawyer's office before their RBD, and those who show up after their RBD. If a client comes to a lawyer before his or her RBD, the client will have a host of planning opportunities. If the client arrives after the RBD, planning will be constrained. An IRA owner's RBD is generally April 1 of the calendar year following the calendar year in which the client reached age 70 1/2. The RBD can be later for certain persons still working when they reach age 70 1/2 under the 1996 amendments to Code 401(a)(9) and for persons who have a Code 403(b) account and retired before 1987.
The Pre-RBD Client
Question 1: Who is the designated beneficiary under the IRA?
Lawyers should include this question in their client questionnaires. If the client has named a spouse, the lawyer should determine whether the client and the spouse are still married and if the spouse is still alive. If a trust is the beneficiary, the lawyer should determine whether the client has gone through the "trust hoops" required under Prop. Treas. Reg. 1.401(a)(9)-1, Q&A D-5 and D-6, which contain several well documented traps.
Question 2: Has the client designated charities to receive any funds under a living trust or will?
The answer to this question will indicate whether the client is chari-tably inclined. If the client has made a pecuniary gift to a charity, there are a few caveats for the lawyer. The client's executor should not necessarily use IRA assets to fund a pecuniary gift to charity because doing so will accelerate the built-in income tax and a charitable deduction may not be available to the estate under Code 642(c) (e.g., there is no deduction unless the payment is pursuant to a will or trust). If the client wants to make a gift to charity, the lawyer should establish a separate subaccount in the IRA for the charity. If the executor funds noncharitable pecuniary bequests with the IRA, the IRD will be accelerated and no charitable deduction will be available. The same is true for any other pecuniary gifts that the executor funds with an IRA. If a client's will makes pecuniary gifts in excess of his or her non-IRA assets (or non-IRD items), the lawyer should consider redesigning the estate plan to minimize the income tax payable by the estate.
Question 3: Is the client married?
If the client is married, in many situations the client should designate his or her spouse as the primary beneficiary of the IRA. Under Code 401(a)(9), a surviving spouse can roll the assets of a decedent's IRA over and treat those assets as his or her own, thus allowing the surviving spouse to name new beneficiaries. In addition, if the surviving spouse receives 99% of the decedent's retirement assets, the spouse can elect to treat the IRA as his or her own for excess accumulation tax purposes under Code 4980A(d)(5), allowing the spouse to defer and possibly avoid the tax. If the surviving spouse is the beneficiary of a marital trust that receives the IRA, however, the spouse will not be able to make the Code 4980A(d)(5) election.
If the client is not married and is likely to have a taxable estate, the lawyer should advise the client to consider giving the IRA to charity to reduce death taxes. Alternatively, the lawyer could advise the client to divide the IRA into subaccounts, with enough in a charitable subaccount to ensure that no estate tax or a reasonable amount of estate tax is payable, and the remainder in subaccounts for children and grandchildren. See Prop. Treas. Reg. 1.401(a)(9)-1, Q&A H-2.
A conscientious client can adjust the subaccounts on an annual basis to arrive at a figure in the charitable subaccount that will result in no or little estate tax. For instance, consider the earlier example of Mrs. Able but assume that she has only $300,000 of non-IRA assets plus $600,000 in an IRA. The lawyer could set up a $300,000 subaccount in Mrs. Able's IRA with Baker University as the beneficiary. From time to time, the lawyer should review Mrs. Able's situation to see if she should allocate more to the Baker subaccount. Most IRA custodial agreements clearly permit the creation of subaccounts, and brokers and trust officers are increasingly aware of and helpful in establishing subaccounts. The client's tax apportionment clause warrants close attention to ensure that any tax payable comes out of the charity's share if that is the client's wish.
Question 4: Does the spouse have a significant IRA?
The two-professional family is becoming quite common; frequently both spouses have large IRAs. A suggestion that each spouse designate the other as beneficiary may set up the survivor for unnecessary excess distributions or accumulation tax and income tax.
Consider the following example. Each of two spouses has a $2 million IRA, and half of each IRA is considered excess. If the lawyer recommends that the spouses name each other as beneficiaries, the surviving spouse would have $2 million of IRA assets (and possibly more) considered excess, depending on his or her investment experience. To avoid the excess accumulation tax, the surviving spouse would have to draw down $2 million, incurring upwards of 50% in income taxes (depending on the rate of state income tax) and, after January 1, 2000, an additional 15% in excess distribution tax. By suggesting that the spouses name one another as beneficiaries, the lawyer may have inadvertently placed the IRA assets in a 65% tax bracket.
Both spouses need not have such large IRAs for this problem to exist. Assume again that the first spouse to die had a $2 million IRA, $1 million of which is excess, but that the surviving spouse had a $500,000 IRA. If the surviving spouse makes a rollover election, his or her IRA for excess accumulation tax purposes will be $2. 5 million. If the surviving spouse invests the assets of the IRA reasonably well, he or she could expose more than $1 million of the IRA assets to the excess accumulation tax.
As an alternative, if the couple is charitably inclined, the lawyer should consider advising the clients to designate CRTs as IRA beneficiaries. By doing this, the lawyer can ensure that the unitrust or annuity amount from the CRT will be available to the surviving spouse as an additional source of income for his or her lifetime. When the CRT receives the IRA, no estate tax will be due on account of the marital and charitable deductions. Furthermore, the distribution of the IRA to the CRT will be free from income tax because the CRT is tax exempt. Finally, when the surviving spouse dies, the IRA will not be treated as part of the surviving spouse's estate for excess accumulation tax purposes, although the excess accumulation tax would apply in the example given at the death of the first spouse to die.
The lawyer should understand that the tax savings from using a CRT do not necessarily inure to the client's loved ones. Rather, the charities will receive more cash and the clients will have "psychically" benefited if they are charitably inclined. Assume in the example given that the first spouse to die left the IRA to a 9% charitable remainder unitrust, with the unitrust amount payable to the surviving spouse during his or her lifetime, and that the IRA assets can reasonably earn and distribute 9% each year. If the client directed that the excess accumulation tax will come out of the charity's share, the charity will receive approximately $2 million when the CRT terminates.
This amount will exceed, in almost all cases, the amount the charity could receive from the IRA if the client had left the IRA to the surviving spouse because, under the minimum distribution rules, the surviving spouse's distributions would have to increase as he or she grew older. In other words, by advising clients to consider giving the IRA to a CRT, the lawyer has afforded the clients the opportunity to give their unneeded retirement assets to their college, their church, the opera society or a museum, rather than to the government. Most clients appreciate the opportunity to make this choice.
The CRT technique is not without drawbacks. First, the only amount payable to the surviving spouse during his or her lifetime will be the unitrust or annuity amount; the spouse will not have the option to withdraw assets in excess of this amount. Second, the entire unitrust or annuity amount will likely be taxable income to the surviving spouse under the four-tier federal income tax scheme applicable to CRT distributions. Third, the surviving spouse will not be able to roll over the IRA assets and choose his or her own beneficiaries or defer the imposition of the excess accumulation tax. A lawyer can mitigate this problem by directing in the client's will or trust that the client's estate pay any excess accumulation tax out of the IRA before it is transferred to the CRT. The applicable state death tax apportionment statute may cause the same result. A final drawback is that if the client designates the CRT as the IRA beneficiary, the client will only be able to use his or her life expectancy to calculate the required minimum distributions.
A disclaimer based plan could avoid some of these problems. The client could designate his or her spouse as the primary IRA beneficiary, with the CRT as the secondary beneficiary. At the client's death, the spouse and advisors would carefully review the situation. If the spouse determines that the unitrust or annuity amount payable by the CRT is all the cash flow from the IRA that the surviving spouse needs, the spouse could disclaim the interest in the IRA and allow it to pass to the CRT.
In choosing whether to distribute assets directly to a CRT or to use a disclaimer-based plan, the lawyer should name the CRT as the direct primary or secondary beneficiary of the IRA to avoid unnecessary acceleration of the distribution. Acceleration could occur, for example, if the client names his or her spouse as the IRA beneficiary and his or her estate as alternate beneficiary with the idea that the client's executor would allocate the IRA after the disclaimer to the CRT. It is quite possible in this situation that all of the IRD in the IRA would be accelerated because of the intermediate distribution of the IRA assets to the estate to fund the CRT. Also, the lawyer may want to consider funding the CRT with some minimum amount before the client's death to affirmatively establish its existence.
Question 5: Do the client and the spouse need the IRA for future living expenses?
Some clients have relatively small IRAs and do not plan to use the IRA as a source of funds for living expenses. They may have other sources of income such as real estate rentals, pensions or stock dividends. Because of the built-in income tax on the IRA, clients in this situation should consider giving their IRA assets to charity. If the client does not have a taxable estate and wishes to protect his or her surviving spouse's potential long-term needs, a charity or CRT could be a secondary beneficiary for disclaimer purposes, as discussed above.
The Post-RBD Client
The next series of questions is intended to guide the lawyer through the options available to the post-RBD client. The post-RBD client is the most likely candidate for some kind of IRA-to-charity technique.
Question 1: Did the client fail to designate a beneficiary before his or her RBD? If the client did not designate a beneficiary before his or her RBD, what are the consequences?
Code 401(a)(9)(B)(i) requires that, when an IRA owner dies after his or her RBD but before the entire IRA has been distributed, the remaining portion of the IRA must be distributed at least as rapidly as it was being distributed on the date of the owner's death. If the client was recalculating his or her life expectancy, the IRA must be distributed by the end of the year following the year of the client's death. If the IRA owner was not recalculating his or her life expectancy, the IRA beneficiaries can use the remaining years of the deceased owner's life expectancy to take distributions. Either way, the payout schedule will be abbreviated.
Can this short payout schedule be avoided? If the client has not named a beneficiary before the RBD, the client will have forfeited the ability to use both his or her and another individual's life expectancy to calculate the client's minimum distributions during the client's lifetime. This does not, however, mean that the client cannot name a new beneficiary. Rather, the client simply cannot use the new beneficiary's life expectancy to measure minimum required distributions after the client makes the new beneficiary designation. If the client has not named a beneficiary, then he or she could name a charity to reduce estate taxes. As shown in an earlier example, clients should favor IRA assets over non-IRA assets when making charitable gifts.
If the client does not want his or her entire IRA to go to charity, the lawyer should suggest that the client designate a CRT as beneficiary. At the client's death, the whole account will be distributed to the CRT. This distribution will not result in any immediate income tax because the CRT is tax-exempt. The client's loved ones can then enjoy an income stream from the CRT. If the client is married, the lawyer should carefully analyze whether the client's estate will need the marital deduction to avoid estate taxes. If the estate will need the marital deduction, then the lawyer should recommend designating the spouse as the only income beneficiary of the CRT to obtain the marital deduction for the spouse's interest in the CRT.
Question 2: Did the client name a beneficiary who is now deceased?
A client with a deceased designated beneficiary is in an unfortunate situation. If the client had named his or her spouse as beneficiary, the lawyer should inquire whether both client and spouse elected to recalculate life expectancies. If they did, then at the client's death, both the client's and the deceased spouse's life expectancies are zero under the recalculation method and the entire IRA must be distributed by the end of the year following the year in which the last of them dies.
If a deceased couple's children or grandchildren are the secondary beneficiaries, there will be a significant income tax payable after the client dies. What can the lawyer suggest under these circumstances? The charity or the CRT solution may help reduce taxes.
If the client's only goal is to reduce estate taxes, the client should designate a charity. If the client wants children, grandchildren or other individuals to benefit from the income of the IRA without triggering income tax rules on the initial distribution of the IRA to the estate, the client should name a CRT as beneficiary.
The client could also use a CRT if the client has remarried after the client's RBD. The CRT will ensure that the client's surviving spouse will have a lifetime income stream because the CRT will make annual unitrust or annuity payments throughout the surviving spouse's lifetime. If the client uses a CRT in this manner, the IRA will not be subject to any estate tax, although it could be subject to the excess accumulation tax on the client's death.
Question 3: Does the client want to name a new beneficiary?
If the client wants to name a new beneficiary of a qualified plan (but not an IRA), the lawyer should be aware of the rules under the Retirement Equity Act of 1984 (REA), which require spouses to consent to beneficiary changes in some instances. Code 417. If the client complies with the REA rules, the lawyer must review the choices that the client made on life expectancy recalculation. If the client has elected to recalculate, when the client dies the account must be distributed rather quickly. The lawyer is left with an analysis similar to the previous question: if a full charitable deduction is desired, the client should consider designating a charity as the beneficiary. If the client wants to create an income stream for one or more individuals, the CRT may be appropriate.
Mitigating the Excess Accumulation Tax
Distributing an IRA to charity does not avoid the 15% excess accumulation tax imposed under Code 4980A(d). If the client's estate is likely to pay an excess accumulation tax, the client has some options. First, the client could direct in estate planning documents that any excess accumulation tax attribu-table to an IRA that the client gives to charity be paid out of the amount going to the charity. Because an estate may take an estate tax deduction under Code 2053 for the excess accumulation tax, the estate will not face a reduced charitable deduction. Consider a $2 million IRA, $1 million of which is considered excess. If all of the IRA passes to charity with the direction that the charity pay the excess accumulation tax, the estate will obtain an $850,000 charitable deduction and a $150,000 deduction for the excess accumulation tax. The result is the same as if the estate obtained a charitable deduction for the full $1 million gift.
If a client is concerned about the excess accumulation tax and has come to the lawyer before the client's RBD, the lawyer has some other tools to consider. The lawyer could simply set up separate accounts under the IRA, with one account designating a charity as beneficiary and the others designating, for instance, the client's children as individual beneficiaries. The client's will could direct that the charitable account bear any excess accumulation tax.
During the client's lifetime, the client could make transfers among the subaccounts to ensure that the charity receives enough assets for the estate to obtain the desired charitable deduction plus the cash to pay the excess accumulation tax. After the client's death, his or her children could draw down their separate accounts with reference to their life expectancies. This can be a powerful savings tool for the children. For instance, if a 40 year old child received a $100,000 IRA and invested the after-tax minimum distributions at 8% (pre-tax) while the IRA also earned 8%, the total value of the IRA and the minimum distribution investments would be approximately $950,000 when the 40 year old turned 80, an after-tax return of approximately 5.45% and a pre-tax return of approximately 9.4%.
This article is intended to alert lawyers to situations in which their clients should consider IRA-to-charity techniques. Charitable gifts can make sense for many clients and can alleviate some of the heavy taxes associated with estate planning for IRAs. Lawyers must be familiar with the technical rules governing distributions from IRAs, the estate tax charitable deduction and CRTs before dispensing advice in this complicated area.
Stephen P. Magowan is an associate with Gravel and Shea in Burlington, Vermont.
Probate & Property Magazine is published six times annually and is included in section members' annual dues.