Typically, giving an inheritance is a great way to ensure that your loved ones are provided for. Unfortunately, without careful planning, your loved ones can be burdened by heavy taxes that may drain the assets you left behind. If you have a non-Roth IRA, it may be an advantage to your loved ones if you do not designate them as beneficiaries and leave the IRA to a charity instead. How does this work?
An IRA is an Individual Retirement Account. An IRA is usually set up by an individual while other retirement accounts, such as 401Ks, are set up by employers. A non-Roth IRA, also called a “traditional IRA,” which is the type discussed here, is basically a savings account that allows a person to take pre-tax income and save or invest it until the account holder is 70 ½. At that point, the account holder is required to take a certain distribution of the money each year. Unlike other types of accounts, money in an IRA is only subject to income tax when it is withdrawn (because the account is made up of pre-tax dollars). If you die before using up your IRA, whomever you designated as your IRA beneficiary has to pay that tax when he or she receives the money. There is one, big exception: if you make that beneficiary a charity. Giving your IRA to charity might benefit your loved ones by reducing the amount of income taxes they may have to pay on assets they inherit from you.
You and your loved ones could particularly benefit from designating a charity as beneficiary if you already plan to give to charity or if you have a substantial estate.
If you already plan to give something to charity:
If you already plan to give to charity, the best way to give value to your loved ones is to give them other assets, and leave the IRA, or a portion of it, to charity. Assets besides IRA accounts are generally not subject to income tax upon transfer because they were taxed when they were earned. For example, when you put a paycheck in a bank account, that money was taxed before you ever got the check, so it will not be taxed when you withdraw that money. In contrast, when you put money in an IRA account, that money has not been subject to income tax so it will be taxed when withdrawn. That also means that it will be taxed when it passes to a beneficiary. Because IRAs are taxed as income upon transfer, they actually end up giving the beneficiary less value, as part the sum will go to pay taxes. This isn’t true, however, if the beneficiary is a charity because charities are exempt from paying income tax. So, your loved ones will benefit more if they receive non-taxable assets, but a charity will benefit equally regardless of which assets it receives.
For example, if Joan has a $500,000 bank account and a $500,000 IRA and she plans to give half to her children and half to charity, Joan’s children will receive more money if given the bank account. With the bank account, Joan’s children will receive the full $500,000. With the IRA, Joan’s children will receive $500,000 minus the amount of the income tax. In fact, if Joan’s children have a modest income, this amount could put them into a higher tax bracket resulting in higher tax rates on their entire income. While the children are better off receiving the $500,000 bank account, the charity receives the same amount no matter which assets it receives. Because it will not be subject to an additional income tax, a charity will get the $500,000 from the bank account or the $500,000 from the IRA. Since it does not matter to the charity and since Joan’s children would benefit from receiving the bank account, the charity should be designated as the beneficiary of the IRA.
If you have a substantial estate:
If you have a substantial estate, you might want to consider giving to charity in order to stay below the estate tax exemption. The combined federal estate and lifetime gift tax exemption for individuals who die in 2015 is $5.43 million. That means, for example, that if you have a $2 million bank account, a $3 million investment portfolio, and a $1 million IRA, your total estate is worth $6 million and will be taxed! Your estate will have to pay taxes on $570,000 at 40% (the difference between $6 million and $5.43 million). By designating a charity as the beneficiary of your IRA, you not only have donated $1 million to charity, but you have also lessened your taxable estate by $1 million. That means your estate is only worth $5 million and none of it is subject to the federal estate tax. Paying no income tax on the IRA and no estate tax results in more value for your beneficiaries!
If you only want to give a portion of your IRA to charity, there are ways to do this as well. For example, you could designate a charity as the beneficiary of a percentage of your IRA, such as 25%, with the remaining 75% going to family. Alternatively, a Charitable Remainder Trust (CRT) allows you to give some of your IRA to an individual for a period of time and then give what is left to charity. A CRT could be set up to give your spouse the required minimum distributions from your IRA for his or her lifetime; then, when your spouse passes, anything left in the IRA account would go to the charity of your choice. CRTs and other trusts have to be set up just right, so it is a good idea to consult with an estate planning attorney if you want to do take this route.
Traditional IRAs are unique in that they are taxed as income when distributed. This can be a disadvantage to the beneficiary and to the entire estate. Strategic planning can help lessen the tax burden on your assets and thereby give more value to your beneficiaries. One way to lessen the tax burden is to name a charity as beneficiary of your IRA. There are two things in life you can’t avoid: death and taxes; but with strategic planning and gifting, you can avoid or lessen the amount of taxes your loved ones pay on your estate after your death.