Retirement funds and charitable planning may not be two areas most people would naturally think to combine. But in many cases, donating retirement benefits to charity can be an ideal solution, both for the donor and the recipient.
The first and best reason to leave retirement benefits to a charity is, as with any philanthropic gift, to benefit the organization. If you don’t want to help a particular charity achieve its goals, there is no advantage to making any sort of gift. While you can certainly make charitable gifts in more or less cost-effective ways, the point of giving is to transfer assets to a cause you wish to support. Leaving retirement benefits to charity may help achieve other estate planning goals, as I will discuss later in this article, but only if philanthropy is already a priority.
That said, once you have one or more charities in mind, few people want to cut the government a larger piece of the pie than necessary. Giving retirement plan dollars to charity can be a highly tax-efficient use of your savings. Note that, throughout this article, the retirement benefits I am discussing are those where distributions typically trigger income tax, such as traditional IRAs or qualified retirement plans. Roth plans, where distributions are income tax-free, do not offer any particular advantage for charitable giving.
Since charities are exempt from income tax, they can receive gifts of retirement benefits tax-free, as long as the gift is structured correctly. Retirement plan assets are therefore worth more to a charity than they would be to an individual who would have to pay tax on any distributions.
In contrast, an inheritance is not considered income, so inherited cash would not be liable to income tax. Heirs must pay capital gains tax on other inherited assets such as stock or bonds, but generally only on gains that occur after the decedent’s death; taxes on gains that accumulated during the decedent’s lifetime are forgiven through a so-called step-up in the asset’s cost basis to its date-of-death value. A retirement plan, on the other hand, does not receive this stepped-up basis.
There are situations in which leaving retirement benefits to charity might not be an ideal estate planning solution. A young individual beneficiary may, in fact, do better to inherit a retirement plan than to inherit an equivalent amount of after-tax dollars. This is because, if he or she makes use of the mechanism that stretches payouts over the beneficiary’s life expectancy, the power of income tax deferral may leave the beneficiary better off.
The minimum distribution rules for retirement accounts also mean that you could end up leaving the charity relatively little if you live long enough to exhaust most of the plan’s value. Long-lived plan participants may wish to consider giving their minimum required distribution directly to the charity each year, or revising an estate plan to provide for the charity in a different way as the retirement plan diminishes in value.
How To Make A Charitable Gift With Retirement Benefits
If you plan to leave your retirement plan to a charity, there are several ways to go about it, each with its own advantages and disadvantages. Maybe the most straightforward way is to simply name the charity directly as the beneficiary of 100 percent of the plan’s value at death. Income tax is easily avoided, and the estate tax charitable deduction is available for the full value of the gift. This method also works if you leave a retirement account to multiple beneficiaries, as long as all of them are charities. With this method, it is important to make sure all paperwork is in order. Some plan administrators may require documentation before allowing the charity to collect the benefits, so it is important to make sure that no one involved is taken by surprise.
If you wish to split a retirement account among several beneficiaries, and not all of them are charities, planning becomes slightly more complicated. The general rule is that either all beneficiaries must be individuals, or none of them can use the life expectancy payout method. If you name your son and a charity as equal beneficiaries of your IRA, unless you take additional measures, your son will be forced to forego the income tax deferral he could otherwise enjoy. Note that if your spouse is the only non-charitable beneficiary, this issue is not a concern, since he or she can simply roll over the share of benefits into his or her own retirement plan.
There are two ways to work around this rule. If the beneficiaries’ interests in the retirement plan constitute “separate accounts,” each account is treated as a separate retirement plan, so individuals can take advantage of the stretch payout options. This method is useful, but risky, because beneficiaries must establish separate accounts by December 31 of the year after the year of the plan participant’s death; if they do not, the less beneficial rules automatically take effect. The other option is for the charity to receive a full payout of its share by September 30 of the year after the year of the participant’s death. In this case, the charity is “disregarded” as a beneficiary and individual or individuals can take distributions as they would if no charity had been named.
You do not have to split up the account by percentages. You can also designate a fixed-dollar amount to go to charity, and leave the remainder to other heirs. However, anecdotal evidence suggests that some IRA plan administrators will not accept such designations on a beneficiary form. In addition, this sort of designation can trigger the same problem discussed above; depending on how the fixed-dollar gift is structured, the option of separate accounts may not be available (though the September 30 payout method will be). If this sort of gift is small, it may make more sense to forego the slight tax benefit and simply make the charitable bequest from other assets and leave the retirement funds solely for individual beneficiaries. Alternately, you could make the gift to charity conditional on payment by September 30, though this will require careful planning to make sure the estate receives the proper charitable estate tax deduction.
There are a couple of other ways to protect the interests of individual beneficiaries when leaving a fixed-dollar amount to charity. You could separate your retirement account into two separate accounts, leaving one entirely to the individual beneficiary, and dividing the other between a set gift to charity and the residue to the individual. While a little of the individual’s benefit may not eligible for stretch payments, the bulk of it is protected. If the account is not separated, you may also be able to count the fixed amount of a gift to charity as the account’s minimum required distribution in the first year after the participant’s death.
Some donors may wish to leave an amount that is neither a fixed amount nor a percentage, finding it more convenient to determine the amount using a formula based on the size of the overall estate or with adjustments depending on other amounts passing to the charity. IRA providers may refuse to accept such designations, however, since the provider has no way to know the total size of the participant’s estate and may not be inclined to get involved in complicated accounting matters. Some providers will allow you to specify that your executor or other fiduciary will calculate and provide the formula amount, relieving the IRA provider of this responsibility. Obviously, in this instance, it is essential that this responsibility is assigned by the proper estate planning documents.
Naming a charity as a beneficiary directly, whether alone or in conjunction with others, may be the most straightforward solution, but it is not the only way to make this type of gift. If it is not feasible to name a charity as a beneficiary for any reason, there are several alternatives. You can leave the benefits to a trust, with instructions that the trustee distribute the assets to the charity. This option, however, creates substantial complexity regarding minimum required distributions and fiduciary income taxes. As an alternative, leaving the retirement benefits to a donor-advised fund, which is tax-exempt itself, will sidestep many of these problems, though donor-advised funds have their own drawbacks as well as benefits.
You can also leave the retirement benefits to your estate, with instructions in your will or other estate planning documents that the executor should then give the money to the charity. The estate is entitled to an income tax deduction for amounts paid or set aside for charity, but as with leaving benefits to a trust, this option is complicated and requires expert knowledge, both at drafting and execution.
If you wish to encourage philanthropy in an individual heir, such as an adult child, you can make a disclaimer-activated gift instead of making a gift outright. For instance, you could name your daughter the plan’s primary beneficiary, with the charity as a contingent beneficiary, specifying that the charity would receive any benefits your daughter disclaims. You may or may not express a wish that your daughter leave all or part of the benefits to the charity. Either way, this disclaimer allows your primary beneficiary to redirect all or part of the benefits to the charity without paying income tax on them first.
Types Of Charitable Entities
Up to this point, I have simply said “charity” when discussing the object of a philanthropic gift. In order to secure the beneficial tax treatment I have mentioned, it is important to understand which organizations are appropriate choices for making a gift of retirement benefits. Most of the techniques in the prior section rely on the assumption that the charity is tax-exempt.
A public charity, which you may sometimes hear described as a 501(c)(3) organization, is what most people mean when they simply say “a charity.” These organizations meet a variety of requirements imposed by the Internal Revenue Service in order to secure and maintain tax-exempt status. Gifts to such organizations present the fewest complications, though it is best to verify that the organization is truly exempt. For most charities, this will not be a problem.
Private foundations are generally also suitable recipients. They are also 501(c)(3) organizations, but are primarily supported by the contributions of one donor or family. While a bit more administratively complex than public charities, private foundations will also offer similar tax benefits (though there are stricter limits for income tax purposes on gifts to many private foundations). There are a few special rules that may come in to play with this sort of gift, which are beyond the scope of this article, so you will probably need advice from professionals with training in this area. Also note that you may not make a disclaimer-activated gift where the individual beneficiary is a trustee or manager of a private foundation and the foundation is the contingent beneficiary.
As mentioned in the preceding section, donor-advised funds are suitable recipients for retirement benefits as well. By leaving assets to a DAF with family members as advisors, you may encourage philanthropy in your heirs while taking advantage of the fund’s income tax-free nature. Take care to make sure that the fund you choose, however, meets the applicable requirements to assure the tax-free nature of the contribution.
Charitable remainder trusts (CRTs) that meet certain requirements are also income tax-exempt. Those that meet the requirements can be suitable recipients for retirement benefit gifts. This strategy can benefit the individual heirs of the trust through an annual payout, either a fixed dollar amount (in a charitable remainder annuity trust) or a fixed percentage of the trust’s value (in a charitable remainder unitrust). Note that, as with many trusts, the administration can be relatively complicated and costly, and it is important to secure expert help in setting up a trust correctly. It is also important to know that qualified plan benefits have certain federal law protections that may mean your spouse must give consent before you can leave such benefits to a CRT. It can sometimes be appropriate to leave retirement account benefits to a charitable lead trust (CLT). However, unlike CRTs, CLTs are not exempt from income tax. For that reason, usually there are better ways to give retirement benefits to a charity (and better ways to fund the trust).
If you wish to support a beneficiary while also giving to a charity, some charities will allow you to fund a charitable gift annuity with retirement benefits. My colleague Rebecca Pavese has written about CGAs in more detail in a prior article. This approach avoids several of the complications created by leaving benefits to a CRT.
You should avoid leaving retirement benefits to a pooled income fund. Such a fund is maintained by the charity that will ultimately receive the gift. The organization pools the gifts of many donors, investing them and paying back a share of the fund’s income to the donor or a named beneficiary. When the donor or beneficiary dies, his or her share of the fund reverts to the charity. Such funds have use in life mainly as a lower cost alternative to a CRT. However, pooled income funds are not income tax-exempt, even if the charities running them are. All the benefits discussed in the previous section would therefore be lost.
Most people will probably want to continue using their retirement accounts during their lifetime, but this consideration does not apply to everyone. Making charitable gifts with retirement benefits, therefore, does not only have to be an estate planning technique.
In most cases, the only way to give assets in a retirement account to charity during your lifetime is to withdraw the money first. This generally means the withdrawal will be taxed. If you make the gift in the same year as you take the distribution, the income tax charitable deduction could theoretically offset the tax on the distribution. Unfortunately, various restrictions including the percent-of-income limit on charitable contribution deductions, deduction reduction for high-income taxpayers and others mean that this is most likely not the case. Taxpayers who use the standard deduction rather than itemizing will not see any tax benefit from their gift.
Some of these drawbacks can be avoided by using smaller distributions and gifts. In addition, it is worth considering donating your minimum required distribution if you do not need it for other purposes. You must take your MRD annually from IRAs and other plans after a certain age. While it does not receive special tax treatment, you have to take the distribution regardless, and a charitable gift may well bring at least some tax benefit.
At this writing, Congress in considering efforts to revive a rule (which expired in 2013) that allowed individuals over 70 1/2 to transfer funds directly from an IRA to a charity without taking a distribution first. If this option returns, it has narrow limits, but is obviously beneficial for lifetime gifts from IRAs.
Retirement plan participants who take distributions before age 59 1/2 are usually subject to penalty taxes. However, if a young participant wants to pledge annual gifts to a charity, an exception known as the “series of substantially equal periodic payments” might make this possible. Because this exception must meet extensive IRS requirements, you should strongly consider consulting a professional to arrange such a gift.
Some sorts of distributions are not subject to full normal income tax, which may make them better suited to charitable giving. For instance, distributions of employer stock from a qualified plan receive special favorable treatment. Any appreciation above cost basis that occurs while the stock is in the plan is called net unrealized appreciation (NUA), and is not taxed until the stock is sold. If you hold stock that has untaxed NUA, you could contribute it to a CRT, avoiding capital gains tax while generating an income tax deduction.
Thinking about your retirement accounts and your philanthropy together, while not always intuitive, can offer benefits in both areas. Depending on your personal situation and your goals, your retirement benefits could be just the right fit for fulfilling your charitable aims.