Benefits of Donating Retirement Assets to Charity

The American Taxpayer Relief Act of 2012 contained several provisions that may affect your clients' charitable giving strategies in 2013. Among the changes, the current law allows direct donations to charities from IRAs1. But, it is important to note that private foundations, supporting organizations, and donor-advised funds — such as the Giving Account at Fidelity Charitable — do not qualify to receive tax-free distributions from IRAs. However, these entities can accept donations of the assets in an IRA at death, either through an IRA beneficiary designation or through a will.

This article focuses on inheritances from traditional IRAs, 401(k)s or 403(b)s that consist only of pre-tax contributions and associated earning. Withdrawals from these accounts are subject to income taxes2. (For simplicity's sake, we will use the shorthand "IRA" when discussing these accounts.)

IRA inheritors may lose a lot to taxes

Together, estate taxes and income taxes may substantially diminish an inheritance from a traditional IRA, 401(k) or 403(b). The first $5.25 million of a taxable estate is free from federal estate taxes — this is called the "basic exclusion". (A surviving spouse can also claim the unused portion of a deceased spouse's basic exclusion, for a combined exclusion of $10.5 million for a married couple. To claim the unused spouse's portion, an estate tax return for the decedent spouse must have been filed, even if no taxes were owed.)

Additionally, income attributable to the decedent is not only included in the decedent's estate, but often subject to income taxes:

  • Income attributable to a decedent that is received after his or her death is considered "income in respect of a decedent" (IRD). IRD includes withdrawals after death from a decedent's IRA, 401(k), 403(b) or similar retirement account.
  • Typically the person(s) receiving the IRD must include the income on their own tax return and pay income taxes on it at their own income tax rate.
  • As of 2013, the maximum federal estate tax is 40% and the maximum federal income tax rate is 39.6%

A client may be able to eliminate or reduce these taxes by strategically giving assets based on the type of asset and the type of beneficiary.

Planning wisely

  • Note which assets can be easily liquidated to pay estate and other taxes. You clients could consider not leaving these assets to specific individuals so the estate can have them available to pay taxes
  • To help reduce the income tax burden to individual recipients, consider leaving individuals assets that have tax-free income (e.g., a Roth IRA) or whose basis can be stepped up at your death (e.g., real estate or appreciated securities in a taxable account)
  • Consider donating assets that will be subject to income taxes to qualified charities:
  • A tax-exempt public charity can withdraw pre-tax monies from non-Roth retirement accounts, such as Traditional IRAs and 401(k)s without paying income taxes.
  • In addition, an estate could take a charitable deduction which would reduce the size of the taxable estate. For example, if your client has a taxable estate of $8 million, by donating a $1 million Traditional IRA to a qualified charity, your client's taxable estate would drop to $7 million.

Hypothetical case study

Assume your client is a 75-year-old widow who has a net worth of $8 million.

Her assets include:

  • A $1 million Traditional IRA (all pre-tax monies)
  • Real estate valued at $3 million
  • Long-term appreciated securities with a current market value of $4 million

She asks you to compare the consequences of leaving her entire IRA to charity or dividing it between her two grandchildren equally.

Your 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 passes away in 2013 with an estate worth $8 million and that the grandchildren withdraw all the IRA assets this year.

  • The first $5.25 million would be exempt from federal estate taxes under her basic exclusion. (We will assume her deceased spouse used up his entire $5.25 million basic exclusion, so nothing more can be excluded.) As a result, the federal estate taxes would apply to the remaining $2.75 million of the estate. The rates are graduated, but they rise fairly quickly to the top rate of 40%.
  • Each grandchild is married, files jointly, and has an adjusted gross income (AGI) of $960,000, including the $500,000 withdrawal from the inherited IRA. The withdrawal should be considered IRD.
  • Under Internal Revenue Code Sec. 691(c), if they itemize their deductions, each grandchild should be able to claim an estate tax deduction on their own federal income tax returns for the federal estate tax attributed to their portion of the IRD, even though the estate taxes may have been paid by the grandmother's estate out of other estate assets.
  • The estate tax deduction they could claim would be slightly reduced (referred to as a "haircut") because their AGI puts them in an income bracket subject to the limitation on itemized deductions that was reinstated in 2013.

The following chart shows how federal estate and income taxes can significantly reduce an inheritance compared to leaving the entire IRA to charity.

  IRA portion of each grandchild IRA to charity
Amount of IRA $500,000 $1 million
Less: Income tax on IRA withdrawal (39.6% X $500,000) $198,000 $0
Less: Estate tax on inherited IRA* (assumes proportionately paid from IRA and securities) $130,000 $0
Income tax deduction for federal estate tax, permitted under I.R.C. Sec. 691(c) (the "IRD deduction") adjusted for limitations on itemized deductions: $180,200** n/a
Plus: Value of tax savings of "IRD deduction" (39.6% X $180,200) $71,359 n/a
Value of each grandchild's portion of IRA after federal income and estate taxes $243,259 n/a
Total available to give to charity $486,518 $1 million

This is a hypothetical example for illustrative purposes only. It assumes both grandchildren are in highest federal income tax bracket of 39.6%*, claim itemized deductions and pay a portion of the decedent's estate taxes from the IRA. It does not take into account state and local income or estate taxes, the federal alternative minimum tax or other limitations and adjustments beyond the Pease "haircut" limitation on deductions.

* As of the publication date, the 2013 federal estate tax rate schedule had not been issued by the IRS. Estate taxes were estimated using the 2012 schedule for the first $500,000 of taxable estate assets beyond the basic exclusion of $5.25 million, 36% for the next $250,000, 38% for the next $250,000 and 40% for taxable estate assets over $1 million, for total federal estate taxes of $1,040,800 on the whole $8 million estate. It was further assumed the estate taxes were paid proportionately from the more liquid estate assets — the IRA ($1M) and securities ($3M). $1,040,800/$4M = 26.02% effective rate on assets used to pay federal estate taxes.

** To claim the estate tax deduction, the taxpayer must itemize deductions and take it in the same year he is required to report the income in respect of a decedent (IRD). This example assumes the estate had no IRD other than the IRA and had no expenses in respect of a decedent. The estate tax without income or expenses in respect of a decedent was estimated to be $640,800, for a deductible estate tax of $400,000 ($1,040,800 - $640,800). The deduction for each grandchild was $200,000 before the "haircut" of $19,800.

If her goal is to maximize the after-tax assets left to charity and her grandchildren, 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 $243,259 or 49% of each child's inheritance
  • The result of naming a charity, rather than the two grandchildren, as the IRA beneficiary is that $513,482 ($256,741 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 non-tax exempt beneficiaries, such as individual relatives, those heirs will often be able to get a stepped up basis at her death3, reducing the capital gains tax they would have to pay on the assets if they decided to sell them.

Naming beneficiaries on IRAs and other retirement accounts

If an IRA or similar retirement account has designated beneficiaries, the assets in it will generally pass directly to those beneficiaries without going through probate. Most banks and financial services firms have beneficiary forms you can use, or they can provide you with suggested language for naming beneficiaries to these accounts.

If you are thinking of leaving money to a charity, consider using non-Roth retirement accounts for that purpose since inherited Roth assets are generally tax-free to recipients, provided certain conditions are met. Some options to consider:

  • Making a qualified charity a 100% beneficiary of a non-Roth account
  • Indicating that the charity is a beneficiary of a certain percentage of the account, and that the rest should go to individual beneficiaries in particular percentages
  • Specifying a qualified charity as a contingent beneficiary, so that if the primary beneficiary disclaims it, it will go the charity

Advantages of making a donor-advised fund4 a non-Roth IRA beneficiary

Although designating any qualified charity as a beneficiary usually allows an estate to claim a charitable contribution deduction, naming a public charity with a donor-advised fund program — such as the Giving Account at Fidelity Charitable — as beneficiary of a non-Roth IRA gives clients and heirs more flexibility. (As mentioned above, Roth assets are generally tax-exempt to any recipient provided certain requirements are met, so these assets provide a better tax benefit to non-charitable beneficiaries.)

  • When clients are not sure which causes they ultimately want to support after death, instead of naming charitable beneficiaries to their Giving Account, they may choose to name an individual successor(s)
  • Upon the donor's death, the IRA assets will fund the Giving Account. The donor's successor can then make grant recommendations over time to the charities they would like to support.
  • The donor may also specify that the IRA be allocated across multiple Giving Accounts, with individual successors having their own Giving Account5

1 This provision will expire on 12/31/13 unless extended by U.S. Congress.

2 Traditional IRAs, 401(k)s and 403(b)s may contain after-tax contributions that are not subject to income taxes. If they do, there are special tax rules to determine what portion of a withdrawal is attributable to after-tax contributions. Withdrawals from Roth IRAs, Roth 401(k)s and Roth 403(b)s, along with their associated earnings, are generally free from income taxes if certain conditions are met.

3 Under 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.

4 At a public charity with a donor-advised fund program

5 Check with the charity sponsoring the donor-advised fund program to make sure you understand all of the requirements for setting up these accounts, including any minimum investments.

Fidelity Charitable is the brand name for Fidelity® Charitable Gift Fund, an independent public charity with a donor-advised fund program. Various Fidelity companies provide services to Fidelity Charitable. The Fidelity Charitable logo is a service mark, and Fidelity Charitable and Fidelity are registered service marks, of FMR LLC, used by Fidelity Charitable under license. Giving Account is a registered service mark of the Trustees of Fidelity Charitable.

The tax information and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws which may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.


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