Get The Most Bang For The Buck From Your Charitable Bequests

This Week's Quote:

“You're off to great places, today is your day.  Your mountain is waiting, so get on your way”
-Dr. Suess

No one wants to pay taxes.

Never. 

Not even the beneficiaries of assets from an estate. 

Chatting with an executor and/or beneficiaries of an estate is a common occurrence for us.  In these meetings, one of my early questions is whether the decedent had any assets in tax-deferred retirement accounts such as IRAs.  The answer may have far-reaching tax consequences. 

Under today’s estate tax laws, most estate assets receive a stepped-up tax basis from the beneficiary’s cost to fair market value (FMV) as of date of death (or alternate valuation date).  In this scenario, when an estate asset such as shares of common stock is sold by the estate or beneficiary – the taxable gain/loss is the difference between the FMV at date of death and the eventual sales price.  E.g. the decedent held common stock for 50 years and realized significant appreciation which was never taxed.  The estate or the beneficiary then sells the shares at the same price as that at the date of death.  There are no tax consequences.  BUT, this concept of stepped-up basis does not apply to tax deferred accounts which are otherwise taxable at some point during the beneficiary’s life.  The exception being, if monies in the tax deferred accounts are bequeathed to a charitable organization.  In this instance, the charitable organization has no tax to pay being a non-profit organization.  The charitable bequest is deductible to the estate but in today’s current estate tax environment, that deduction may have no value since only estates with values over $12 million dollars are taxed.  If the estate was making a charitable bequest regardless, best to do with essentially before tax dollars.  Otherwise, the beneficiaries would be effectively receiving after tax dollars and have less money.
 
Sidenote:  As of January 1, 2013, the State of Ohio no longer imposes an estate tax.

                             - Mark Bradstreet

Death is a certainty, but some taxes actually aren’t when you make charitable bequests using individual retirement account assets.

“If leaving money to charity is part of your estate planning, there are no better funds to leave than traditional IRA assets. When I explain this to people, a lightbulb goes on,” says Tim Steffen, director of tax planning at Robert W. Baird & Co., who has helped his own family members with such donations.

This strategy is especially relevant given the growth in traditional IRAs over the last decade, even with this year’s selloffs in both bond and stock markets. Traditional IRAs held about $11 trillion at the end of 2022’s first quarter, more than double the $5 trillion they held at year-end 2012, according to latest data from the Investment Company Institute.

Most of that growth is due to asset appreciation and rollovers from workplace plans such as 401(k)s. With the demise of pensions, traditional IRAs are now the largest financial account many people have, especially baby boomers—so it’s worth knowing about tax strategies using them.

Some donors already do. Lesley Mitchell Jones, who retired as a partner after decades at a New York financial services firm, says she is leaving her seven-figure IRA to the Community Foundation of Broward, a charity serving the Fort Lauderdale area where she now lives.

“The foundation will get my IRA assets tax-free after I’m gone, and they’ll give the money over time to causes I’ve designated,” says Ms. Jones.

For smaller donors as well as large ones like Ms. Jones, there are two big benefits to making gifts at death using traditional IRA assets.

The first advantage is tax efficiency. Donors of traditional IRA assets at death can win an income-tax trifecta—no tax on contributions going in, no tax on annual growth, and no tax on assets at death.

This tax outcome contrasts favorably with the treatment of donations of cash or an investment asset such as stock held in a taxable account, especially if there are heirs. Here’s a simplified example.

Say that Jane, a widow with children, wants to leave a total of $20,000 at her death to several charities such as her church and college. She expects to have more than $20,000 in each of three accounts at that time. One account holds cash, one is a traditional IRA holding stock and funds, and one is a taxable investment account holding stock she bought decades ago. Jane wants to minimize taxes and maximize benefits for her heirs and chosen charities.
 
 A $20,000 charitable bequest of assets from any of the three accounts will bring a federal estate-tax deduction. But Jane’s estate, like that of most Americans, will be smaller than the current estate-tax exemption of about $12 million. So, there will be no federal estate taxes to reduce.

This means Jane should focus on minimizing her heirs’ income taxes on the assets she’s leaving them, and donating traditional IRA assets typically does this best. If Jane leaves the IRA assets to her heirs, they will have taxable withdrawals—and the IRA will likely have to be emptied within 10 years, ending its tax-free growth.

Giving IRA assets funnels pretax dollars to the charities, which won’t owe tax on them. A cash donation would be of after-tax dollars.

Donating the IRA assets to charity is also typically better than giving stock held in a taxable account. Under a provision known as the step-up, there is no capital-gains tax on such investment assets held at death.

So if Jane purchased her $20,000 of stock for $5,000, the step-up could save her heirs capital-gains tax on $15,000 when they sell the shares later. This valuable benefit would be lost if she made her donations with stock.

The second advantage of leaving traditional IRA assets to charities is flexibility. Wills are often drawn up years before someone dies, and circumstances change. As a result, the donor may want to name different charities or donation amounts.

Making these changes is often easier with traditional IRAs than a will. For example, an IRA owner could set up a dedicated IRA naming one or more charities as beneficiaries and then move assets from other IRAs into it via direct tax-free transfers. The beneficiaries and the percentage they will receive can easily be changed, and the owner also can raise or lower the total donation by transferring assets between IRAs.

What if the IRA owner is age 72 or older and has to take annual required distributions? There’s flexibility here as well, because the owner doesn’t need to take a withdrawal from each IRA. If a saver has three IRAs and a total required payout of $40,000, he could withdraw $30,000 from one account, $10,000 from another, and none from the third.

A useful twist on this strategy that’s gaining popularity: Leave IRA donations at death to a donor-advised fund like Fidelity Charitable, Vanguard Charitable, Schwab Charitable, or at many community foundations. Before death, the IRA owner officially designates family members (or someone else) to recommend grants of the DAF funds to qualified charities in the future.

The DAF donations don’t have to be made immediately, and the assets can grow tax-free until they are, notes Brandon O’Neill, a planning consultant at Fidelity Charitable.

“Often these givers want to deepen the family commitment to philanthropy, and using IRA assets is a great way to do it,” he says.
 
Ideas and comments come from a WSJ article written by Laura Saunders.  It was published on September 2, 2022.

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
 
This Week’s Author, Mark Bradstreet