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Monday June 29, 2015

Article of the Month

Charitable Planning With IRAs—Part I

Introduction


At the end of 2014, Individual Retirement Accounts (IRAs) held $7.3 trillion in assets and represented 30% of all retirement assets held in the United States.i In addition, 63% of all U.S. households have established an IRA or other tax-deferred retirement plan.ii These plans often constitute a large portion of a person’s estate at death.

Traditional IRAs pose estate planning challenges for owners because when passed to beneficiaries at death a traditional IRA is income in respect of a decedent, meaning the beneficiary must pay tax on the amount received. Thus, while many clients may be content with simply designating a spouse or child as their IRA beneficiary, such a plan may not always be the most tax-efficient strategy. Given that clients often pass away with large IRA balances and therefore leave a large potential income tax bill for beneficiaries, professional advisors should be aware of alternative strategies that can minimize tax and help clients accomplish estate planning and philanthropic goals.

This two-part article will discuss various charitable planning strategies that clients can use to minimize the negative tax consequences of transferring IRAs to heirs. These strategies will be especially helpful in situations where clients wish to leave some benefit to both family and charity after they pass away. Part I of this series will discuss IRA basics, the inheritance challenges IRAs pose and simple charitable planning solutions to deal with these challenges. Part II of this series will provide an in-depth discussion of charitable remainder unitrust strategies to solve challenges IRAs pose for clients.

IRA Basics


Simply put, an IRA is a tax-advantaged way for individuals to save for retirement. Contributions to a traditional IRA may be either fully or partially tax deductible. Generally, an IRA owner will not pay taxes on the amounts contributed to the IRA and will not pay taxes on the earnings inside of the account. With a traditional IRA, taxes will be paid on amounts withdrawn from the account. Unlike employer-sponsored 401(k) plans, an IRA is an account an individual opens up on their own. In 2015, an individual can contribute up to $5,500 ($6,500 if the owner is over 50) to his or her IRA.

Three specific withdrawal rules apply to IRAs. Generally, individuals may not withdraw amounts from their IRA before age 59½ without incurring a 10% penalty, which is in addition to applicable state and federal taxes on the distribution. Between ages 59½ and 70½, an individual can withdraw funds from their IRA without incurring a penalty. Once an IRA owner reaches age 70½ he or she must begin taking required minimum distributions (RMDs). A failure to take an RMD can subject the IRA owner to a 50% penalty.

As a result of the IRA withdrawal rules, many IRA owners with larger IRA balances will not begin withdrawing funds from the account until they are required to do so at age 70½. By then, the value of their IRA will have risen considerably. Assuming they only take the RMD amount each year, the value of the IRA could continue to rise for a number of years. The reason for this is simple: assuming a conservative earnings rate of 6.5%, it is likely that withdrawals do not begin to reduce the account balance until ten years after RMDs commence. At that time RMDs will begin to be 6% and higher. Consequently, many IRAs may continue to grow in value even after RMDs commence, and it is likely that many IRA owners will pass away with substantial amounts of their IRA value intact.

IRA Beneficiary Options


Beyond their tax-advantaged nature, IRAs create certainty for the future. For individuals who only take the RMD, they receive simple uniform distributions each year. Additionally, it is easy for an IRA owner to designate the beneficiary of an IRA using a beneficiary designation form. This beneficiary designation does not require the time and expense of a will or trust. Furthermore, an IRA owner may change the selected beneficiaries at any time. This provides great flexibility as life circumstances change.

The most common beneficiary designation for an IRA is a spouse. But a non-spouse may also be selected, such as a child, trust, charity or some combination of all of the above. Each option comes with its own benefits and challenges.

Spouse as Beneficiary

If an IRA owner names his or her spouse as the beneficiary of an IRA, the spouse has the option of rolling over the IRA into his or her own IRA. In so doing, the spouse becomes the owner of the IRA assets with his or her IRA rules applying to the rolled over IRA. The spousal rollover allows surviving spouses to take RMDs based on their life expectancies and not the deceased spouse’s life expectancy. This provides an obvious advantage for younger surviving spouse because it allows them to delay taking RMDs, if they are younger than 70½, or take RMDs based on their own life expectancies. Whether spouses elect to rollover the IRA or not, they will eventually have to take RMDs and be subject to the RMD distribution schedule. With the spousal rollover the surviving spouse may designate his or her own beneficiaries of the IRA.

Children as Beneficiary

Another common option is for IRA owners to designate their children as beneficiaries. Depending on the circumstances, this may not be a tax-efficient solution.

When a child is selected as the beneficiary of an IRA, the payout will be based on that child’s life expectancy. If there is more than one child, then the payout will be based on the life expectancy of the oldest person. It is possible for each child to receive distributions based on his or her individual life expectancy if the IRA is divided into separate shares for each child.

If the IRA owner passed away before RMDs began, known as the required beginning date (RBD), then the option exists for the children to elect a compressed five-year distribution of the IRA assets. This could result in huge payments and significant taxes to the children. It should be noted here that there is a trend among IRA plan administrators to pay out an IRA in a lump sum to beneficiaries who are not a surviving spouse, which could include children. For this reason, it is recommended that IRA owners review their plan documents to ensure their children avoid a lump sum distribution. Otherwise, children will incur an immediate tax burden, while also receiving more money than they may be capable of managing responsibly.

Trust as Beneficiary

IRA owners may be interested in selecting a trust as the beneficiary of their IRA. This may protect the IRA assets from creditors, control the distributions to heirs or limit minors’ access to funds. However, selecting a trust as the beneficiary of an IRA comes with some drawbacks and complex challenges.

Most individuals who designate a trust as IRA beneficiary will want the trust to qualify as a “see-through” or “look-through” trust. A trust must meet certain requirements under Sec. 1.401(a)(9)-4 to qualify for look-through status. If the trust qualifies as a look-through trust, then the trust’s beneficiary or beneficiaries may receive payouts from the IRA as if they were directly named as the designated beneficiary. If multiple individuals are the beneficiaries of the trust, the IRA payouts will be based on the age of the oldest person. This could create a problem if a trust is established to benefit a surviving spouse and children because IRA payouts will be based on the age of the surviving spouse.

If a trust fails to qualify as a look-through trust, then two unfavorable consequences could result. First, if the IRA owner had not yet reached the required beginning date for taking RMDs, then the IRA must pay out to the trust over a five-year period. This results in immediate and significant tax consequences. Second, if the deceased IRA owner was already receiving RMDs, the trust may not stretch IRA payouts over a child or other beneficiary’s life expectancy. Instead, the trust will receive IRA payouts over the deceased IRA owner’s remaining life expectancy.

The most problematic requirement for look-through status is that the trust beneficiaries must be identifiable as of the date of the IRA owner’s death. This means that if the trust allows beneficiaries to be added or if non-human persons are or could be listed as a beneficiary, then the trust would fail to qualify for look-through treatment. Therefore, careful drafting of the trust instrument is required to avoid the negative consequences of failing to qualify for look-through treatment.

Because of the challenges that come with selecting a trust as the beneficiary of an IRA, some practitioners recommend against this option. It is usually better to name actual beneficiaries that can receive IRA payouts based on their life expectancies than to designate a trust as beneficiary.

Charity as Beneficiary

An option that individuals may consider, especially if they plan to include charity in their estate plan, is to select charity as a beneficiary of their IRA. Charity can receive the IRA tax free and the IRA owner’s estate can receive an estate tax deduction for the value of the IRA passing to charity. As will be seen in the remainder of this article, charity can be an ideal solution to the numerous estate planning challenges IRAs pose.

Drawbacks of Naming Spouse or Children as Beneficiary


As has already been discussed, selecting a spouse or children as the beneficiary of an IRA comes with disadvantages. First, a spouse or child will have limited control over distributions from the IRA. Instead, they are subject to the RMD distribution schedule. If a spouse or child wants income control, such as the ability to receive distributions in one year but not another, the RMD schedule will thwart that desire. This desire for income control is one reason why some IRA owners seek to list a trust as the beneficiary of their IRA, even though selecting a trust comes with its own disadvantages.

Second, selecting children as the beneficiaries of an IRA could be an inefficient tax solution. Not only may children need to pay state and federal income tax on the IRA distributions, but the value of the IRA could be reduced by estate tax. For those IRA owners who have a taxable estate, an estate tax rate of 40% could be levied on the IRA. Combined with a top income tax rate of 39.6% plus possible state income taxes, taxes could deplete more than 65% of the IRA value. That would leave comparatively modest value for children.

Charity as Superior IRA Solution


A client who plans to benefit charity and family in his or her estate plan may choose to designate the IRA to charity and leave other assets to family. Along with savings bonds and commercial annuities, IRAs are considered income in respect of a decedent (IRD). Consequently, it is a “bad” asset to leave to family. Instead, family should receive “good” assets—those that receive a step-up in basis, such as appreciated stocks or real estate. Under this strategy, charity receives the full IRA value income and estate tax free while children receive the “good” assets with a step-up in basis. Those “good” assets may be sold with little to no income tax.

Example 1—Leaving IRA to Charity

Ned, age 67, is the owner of a $500,000 IRA. The other major assets in his $1.2 million estate are a home worth $600,000 and a stock portfolio worth $100,000. He has been a regular donor to his alma mater for a number of years and has been talking to his attorney about his desire to leave a sizeable bequest to the university in his estate plan. Before speaking with his attorney, he was planning to leave most of the IRA to his children. However, Ned’s attorney explained to him that leaving the IRA to his children would cause them to pay a significant amount in income tax on withdrawals from the IRA. Additionally, the children would be required to follow the IRA distribution rules, which could result in untimely distributions.

Instead, Ned’s attorney suggested that Ned leave his IRA to his alma mater and leave his home and stock portfolio to his children. Since the home and stock portfolio will both receive a step-up in basis at Ned’s death, the children will be able to sell those assets and reinvest without incurring a large tax bill. In addition, Ned’s alma mater will receive the full value of Ned’s IRA without paying any income tax. Under this plan, the attorney explained, both children and charity will receive the most value while paying the least tax. Ned liked this plan and decided to leave the IRA to his alma mater and his remaining assets to his children.

Combining an IRA with an ILIT


For many clients, their IRA is the largest asset in their estate. If they left their IRA to charity, their remaining “good” assets would leave an insubstantial inheritance to children or other family members. These individuals may feel their only choice is to leave the IRA to family and may be seeking other tax-efficient ways to benefit charity and family using the IRA.

One such strategy may be to use the IRA to fund an irrevocable life insurance trust (ILIT). This plan can provide children an income and estate-tax-free inheritance while leaving charity as the IRA beneficiary. Under this strategy, the trustee of the ILIT will be both the owner and beneficiary of a life insurance policy based on the life of the IRA owner. Each year the IRA owner will receive an RMD and transfer some or all of it to pay the premium on the life insurance policy. The ILIT trustee will then use the contributed amount to pay the premium on the life insurance policy held inside the trust. Upon the IRA owner’s passing, the ILIT receives the insurance proceeds, which may be distributed to family members as an inheritance according to the trust’s terms. In addition, when the IRA owner passes away charity receives the IRA estate and income-tax free.

An ILIT provides a number of advantages. First, the internal rate of return on the policy could be in the range of 3-4%. Second, the insurance proceeds are income-tax and estate-tax free. The proceeds are estate-tax free because the IRA owner will not retain any incidents of ownership with respect to the insurance policy because the ILIT will be the only owner and beneficiary of the policy. Third, if the ILIT is properly drafted with Crummey Powers, then the annual contributions to the ILIT by the IRA owner will qualify for the gift tax annual exclusion.

Example 2—ILIT

Let’s return to the example of Ned, age 67, who is the owner of a $500,000 IRA. His total estate value is $1.2 million. In talking with his attorney, Ned stated he may not need the RMDs once they begin in a few years. Because of that, Ned’s attorney suggested that he could use some of his RMD to fund an ILIT. The ILIT trustee would then use this amount to pay the annual premium on a $500,000 life insurance policy. Upon Ned’s passing, the life insurance proceeds would then be paid from the ILIT to his two children income, gift and estate-tax free. In addition, by selecting his alma mater as designated beneficiary of the IRA, Ned would be making a substantial gift to the university. Ned liked this plan and decided to establish an ILIT while selecting his alma mater as the IRA designated beneficiary.

Testamentary Gift Annuity


An option that may appeal to some IRA owners, especially those who are more senior and thus have older children, may be to use their IRA to fund a testamentary charitable gift annuity. With a charitable gift annuity, a donor transfers money or property to charity in exchange for the charity’s promise to make fixed annuity payments to one or two annuitants for life. In many cases, the entire amount is held by the charity and reinvested in order to fund the lifetime payments. When the annuitant or annuitants pass away, the charity is allowed to withdraw any remaining funds and use them for its exempt purposes.

There are several reasons why an IRA owner might select a testamentary gift annuity. First, if the beneficiary is fairly senior, the gift annuity will distribute a high fixed payout. Second, a gift annuity can be funded with a relatively small amount, since it is easier and less expensive to administer than a charitable remainder trust. Many charitable organizations allow gift annuities to be funded with amounts as small as $10,000 or $20,000. Third, a testamentary gift annuity will result in an estate tax deduction for the present value of the gift portion of the annuity. For donors who have a taxable estate, the estate tax deduction may help them save estate taxes. Finally, the payout from a gift annuity is fixed, unlike the RMD schedule for IRAs. As such, the IRA owner could ensure that the gift annuity beneficiary does not receive increasingly large amounts of income as time goes on. This may facilitate responsible use of an inheritance for the child.

Example 3—Testamentary Gift Annuity

Kaitlynn has two children, Robb, age 65, and Denise, age 64. She has a $2 million estate including $1 million that she rolled over into an IRA that she inherited from her late husband Todd.

Kaitlynn would like to provide Robb and Denise with fixed payments for their lifetime and an additional inheritance. She and her attorney decide to transfer the IRA to her favorite charity to pay a gift annuity to Robb and to Denise at death. Kaitlynn can fund a $500,000 annuity from her estate for each of her children with the IRA. At current rates, the annuity would provide a 4.7% payout for Robb and a 4.6% payout for Denise.

Because the annuity will be funded with Kaitlynn’s IRA when she passes away, it is likely that Robb and Denise will be more senior and will receive even higher payouts. Based on Robb and Denise’s ages and current payout rates, the annuities will pay Robb and Denise an estimated lifetime distribution of $943,750. Kaitlynn is pleased with this plan.

In addition to the over $940,000 paid during their lifetimes, Robb and Denise will divide the balance of their mother’s estate. Each could receive approximately $480,000 as an outright inheritance. Based upon the expected estate exemption, the estate will not be subject to estate tax. Because the gift annuity is funded with an IRA, the payments will be entirely ordinary income. However, Denise and Robb will not be required to pay tax on the IRA until the payments are received from the charity.

Conclusion


IRAs increasingly make up a significant part of many individual’s estates. While IRAs provide significant advantages that allow individuals to save substantial amounts for retirement, they can be a problematic asset to leave to surviving spouses and heirs. The potential negative tax and distribution problems of IRAs can be mitigated or eliminated through the use of charitable planning strategies. This article discussed the advantages of leaving “good” assets to family and the “bad” asset IRA to charity. By doing so, an IRA owner may save their family significant income and estate taxes. As an alternative to this plan, an IRA owner may want to look into using their IRA to fund an ILIT or a testamentary gift annuity.

Part II of this series will discuss another great charitable planning arrangement, which is to use an IRA to fund a testamentary charitable remainder unitrust. A charitable remainder unitrust can be the optimum way to avoid some of the negative aspects of leaving an IRA directly to family.

Footnotes


i Investment Company Institute, “The Role of IRAs in U.S. Households’ Saving for Retirement, 2014,” p. 2, available at http://www.ici.org/pdf/per21-01.pdf.
ii Id.

Published June 1, 2015
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