Using Retirement Benefits to Achieve Charitable Objectives

Editor: Frank J. O’Connell Jr., CPA, Esq.

Charitable Contributions

For taxpayers who desire to give to charitable organizations, using retirement benefits to make those gifts is an ideal way to accomplish their objectives. Because of the charity’s tax-exempt status, money from retirement plans is effectively worth more to the charity than it would be to a beneficiary who must pay tax on the receipts. If the taxpayer has funded the retirement plan with pretax dollars, the money will go to the charity without ever having been taxed. This item explores a few options for taxpayers to use retirement plan benefits to fund charitable desires.

Lifetime Giving

Qualified charitable distributions: The Pension Protection Act of 2006, P.L. 109-280, created a tax-efficient way for taxpayers age 70½ and older to give to charity any distributions from their IRAs that would otherwise be taxable to them. These qualified charitable distributions were originally available only for 2006 and 2007, but the provisions have been extended until December 31, 2011, by the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, P.L. 110-343, and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312. The law allows taxpayers who are at least age 70½ to exclude from income up to $100,000 of amounts transferred from an IRA directly to a qualified charity. The transferor cannot take a deduction for the charitable contribution, but the ability to avoid the tax on the distribution itself can still be valuable.

Advantages: Among the advantages of making qualified charitable distributions are the following:

• The amount transferred to charity is excluded from income. As such it is not included in adjusted gross income (AGI). Those tax items that are AGI sensitive (e.g., taxable Social Security benefits, medical expenses, miscellaneous itemized deductions subject to 2% of AGI) may be more valuable because of the lower AGI. In states that base the state taxable income solely on federal AGI, the state tax is reduced as well.
• The distribution counts toward the required minimum distribution (RMD) amount.
• The aggregation rules of Sec. 408(d)(2) do not apply.

The third item above is especially valuable for taxpayers whose IRAs contain after-tax contributions, and it may even present planning opportunities. Normally, if a taxpayer’s IRA contains both deductible and nondeductible contributions, each distribution contains deductible dollars (taxable) and nondeductible dollars (nontaxable) in the same ratio that they make up the IRA. For example, if a taxpayer has an IRA with a value of $100,000 and has made $10,000 of nondeductible contributions to the IRA, 90% of each distribution will be taxable and 10% will represent a tax-free return of the taxpayer’s basis in the IRA.

Under the qualified charitable distribution ordering rules, the distribution is deemed to come first from deductible contributions and would “use up” basis only to the extent that the distribution exceeds the aggregate amount that would have been included in the taxpayer’s income if all amounts in the taxpayer’s IRAs were distributed in the tax year. As shown in Example 1, all IRAs are treated as one contract for determining the aggregate amount that would have been included in income.

Example 1: B has two IRAs. The first IRA has a fair market value (FMV) of $75,000 and contains $20,000 of nondeductible contributions. The second IRA has an FMV of $25,000 and contains $5,000 of nondeductible contributions. In 2011, B directs the administrator of the first IRA to issue a check for the full $75,000 to the Red Cross. Under the normal aggregation rules of Sec. 408(d)(2), $18,750 [(25,000 ÷ $100,000) × $75,000] is a tax-free return of basis, while $56,250 is taxable.

Under the qualified charitable distribution ordering rules, the first thing to determine is, if all of B’s IRAs were distributed to him during 2011, how much would be included in his income? B’s two IRAs contain $75,000 of deductible contributions. Therefore, a distribution to B of all amounts in all IRAs would result in the inclusion of $75,000 in income. Any amount up to $75,000 that B directs to be transferred from the IRA to charity will be considered a qualified charitable distribution and will be deemed to come from the taxable portion of the IRAs. This amount will be excluded from his income for 2011. He is left with the second IRA, which is now deemed to consist solely of nondeductible contributions. B could withdraw this amount or convert that IRA to a Roth IRA with no tax consequences.

Limitations: A distribution will be considered a qualified charitable distribution only if the funds are transferred directly from the IRA to the charity. If the taxpayer receives any of the funds, that amount will be included in income, even if he or she then sends the funds to the charity. In addition, qualified charitable distributions are available only for those taxpayers who are age 70½ or older. Finally, the distribution will be considered a qualified charitable distribution only if the entire amount of the payment to charity would qualify as a deduction under Sec. 170. If the taxpayer receives any quid pro quo benefits from the distribution, it will not qualify, and the entire amount will be included in income.

Example 2: S directs her IRA administrator to distribute $20,000 to State University’s Alumni Association, a qualified Sec. 501(c)(3) organization. In return, S receives two season tickets to State’s football games valued at $1,000. Since less than the full $20,000 contribution is deductible under Sec. 170, the $20,000 is not a qualified charitable distribution, and all $20,000 will be included in S’s income. Of course, S can take a charitable deduction for the $19,000, but she will not receive the previously mentioned other benefits of a qualified charitable distribution.

Taxpayers also need to remember that these provisions are due to expire on December 31, 2011, unless Congress extends them again or makes them permanent. Therefore, clients who wish to take advantage of these provisions currently have a short period of time in which to do so.

Series of substantially equal periodic payments: Taxpayers under age 70½ are not eligible for the qualified charitable distribution provisions described above. Although they can withdraw funds from their IRAs, include the distribution in income, and then claim a charitable deduction, younger taxpayers (under age 59½) who may have substantial IRA balances have a further disincentive to contribute any of the IRAs to charity because of the 10% penalty on early distributions. Fortunately, there is an exception to the 10% additional tax on early distributions—the series of substantially equal periodic payments (SEPPs)—that can be useful for these taxpayers.

The details of establishing a series of SEPPs are beyond the scope of this item, but essentially a taxpayer with a large IRA can carve off a portion of it into a separate IRA from which the distributions would be received. The taxpayer could use those funds to accomplish his or her charitable objectives without being subject to the 10% penalty for early withdrawals. The distributions will be included in the taxpayer’s income, but he or she will be entitled to a charitable deduction for any amounts forwarded to charity. (For more on SEPPs, see Burilovich and Burilovich, “Substantially Equal Periodic Payments from an IRA,” 39 The Tax Adviser 670 (October 2008).)

Testamentary Charitable Giving

Taxpayers who want to leave bequests to charitable organizations upon their deaths should consider funding their charitable bequests with retirement plan benefits. For estate tax purposes, any asset (whether a retirement plan or any other asset) that passes to charity is not subject to estate tax. For income tax purposes, assets owned at death normally receive a basis equal to the FMV at death. However, retirement plan benefits are generally considered to be income in respect of a decedent (IRD) and therefore do not receive a step-up in basis upon death under Sec. 1014(a). Noncharitable beneficiaries are required to include the benefits in their taxable income at ordinary income tax rates when withdrawn. As mentioned above, because of the tax-exempt status of qualified charities, they can receive the benefits free of income tax, effectively making the benefits more valuable to the charity than they are to a noncharitable beneficiary. There are several methods taxpayers can use to bequest their retirement benefits to charity.

Beneficiary designation: The easiest way to leave retirement benefits to charity is simply to name the charitable organization as beneficiary of the proceeds. This way the benefits do not become part of the decedent’s probate estate, and the charity can receive the funds very soon after the taxpayer’s death. This method is as easy as putting the name of the charity on the beneficiary designation form of the retirement account.

Taxpayers may not want to leave the full amount of the benefits to the charity. They may instead want only a portion to go to charity and the remainder to go to a noncharitable beneficiary. Taxpayers can also accomplish this on the beneficiary designation form by specifying the percentages to go to charity and to the other beneficiary. One caution about this method is that because a charity is not considered a designated beneficiary for purposes of the RMD rules, the entire retirement account could be tainted with the nondesignated beneficiary status. This could cause the benefits to the noncharitable beneficiaries to be paid out over a shorter time period.

However, a taxpayer can easily avoid this in a few different ways. First, prior to death, the taxpayer can separate the IRA into two accounts, one payable to the charity and the other payable to the noncharitable beneficiary. Or the taxpayer’s estate can simply pay, post-death, the amount of benefits the charity is to receive to the charity by September 30 of the year following the year the taxpayer dies.

Example 3: R designates her local SPCA to receive 50% of her IRA and her son to receive the other 50%. If the IRA is worth $500,000 at R’s death, the executor of her estate can have the IRA administrator issue a check to the SPCA for $250,000. If this is completed by September 30 of the year following the year R dies, R’s son can spread the payout of the benefits over his lifetime under the RMD rules applicable to him, rather than under the shorter time period required under the nondesignated beneficiary rules.

Charitable remainder trusts: A charitable remainder trust (CRT) established under the provisions of Sec. 664 provides a noncharitable beneficiary with an income stream for a period of years (or for life), with the remainder going to charity at the end of the trust term (or the death of the income beneficiary). The payments from the CRT can be denominated as either a fixed dollar amount or a fixed percentage of the FMV of the CRT as recalculated annually. The taxpayer’s estate receives a charitable estate tax deduction for the present value of the remainder interest going to charity. CRTs generally do not pay income tax, so they can receive the full amount of the retirement benefits to invest. Instead, the income beneficiary is taxed on the amount of income distributions as they are received from the trust.

CRTs can be effective tools for taxpayers who may want to divide their retirement benefits between a charity and an older beneficiary. Because of the way the RMD rules work, an older nonspouse beneficiary who inherits a retirement plan will be required to withdraw the entire IRA over an artificially low life expectancy determined by IRS tables. This can accelerate significant amounts of income into a few years. By leaving the benefits to a CRT, the beneficiary can enjoy a more reasonable cashflow without being forced into higher tax brackets.

Example 4: W is an 89-year-old widower who wishes to leave his $1 million IRA to his 80-year-old brother B. If W dies this year, B will have to take his first RMD by December 31 of next year. Based on B’s age and the balance of the IRA, his first RMD will be approximately $103,000, and the entire IRA will have to be paid out (and taxed) to B over the next nine years. If W instead leaves the IRA to a charitable remainder annuity trust that specifies a $60,000 annual payout to B over his lifetime, B will enjoy the benefit of predictable cashflow and will pay tax on only $600,000 over that 10-year period instead of the full $1 million (plus earnings) that would be included in his taxable income if he received the IRA directly.

Charitable gift annuities: Charitable gift annuities are similar to CRTs in that a noncharitable beneficiary receives an income stream and the charity receives the remainder. Unlike a CRT, where the funds are held in a separately invested trust account and the ultimate charitable beneficiary can be changed during the trust’s existence, with a charitable gift annuity the funds are given directly to the charity that ultimately benefits from them. The charity adds the funds to its other assets and then becomes responsible for paying an annuity to the noncharitable beneficiary during his or her lifetime. As with a CRT, the decedent’s estate is entitled to an estate tax deduction for the present value of the remainder benefit passing to the charity. The charity can then withdraw the retirement benefits free of income tax. The beneficiary reports the payments from the charity as he or she receives them (reduced by a portion of any basis the decedent may have had in the IRA). Some advantages of the charitable gift annuity are that a separate trust agreement does not need to be drawn up as with a CRT, and there is no additional tax return to file as there is with a CRT.

Conclusion

Taxpayers typically consider their retirement plans to be primarily funds that will maintain their lifestyles after their working years, with the excess passing to their heirs after their death. However, taxpayers who have acquired other assets in addition to their retirement plans and wish to give assets to charity should seriously consider funding their charitable desires with retirement benefits. During their lifetime (for the remainder of 2011), taxpayers over the age of 70½ can take advantage of the qualified charitable distribution provisions of the Pension Protection Act of 2006. Those taxpayers under age 59½ can structure a series of SEPPs to fund their charitable objectives while avoiding the 10% early withdrawal penalty. At the taxpayer’s death, charities can receive retirement benefits free of income taxes, and noncharitable beneficiaries can receive other assets with a step-up in basis. The estate tax charitable deduction is another attractive plus. It can be a win-win for everyone, especially the charities.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.