Use IRAs for charitable bequests
Tax law treats donations very differently than bequests. Donating appreciated assets to charity during one’s own lifetime avoids the capital gains tax while benefiting a charity.
But bequeathing such assets to charity at death has very different implications. Under current law, appreciated assets get a basis step-up to current value at death, so the heirs won't owe income tax on the gains. On the other hand, if those same assets are left to charity, the tax break is lost.
That's just one reason advisors are recommending that charitably minded clients consider using retirement accounts for bequests. "Required post-death distributions from a traditional IRA or an employer's retirement plan are taxable," says Marcus Miller, a senior financial planner in the Indianapolis office of Deerfield Financial Advisors.
That means that your beneficiary is generally going to need to pay income tax on any distribution from an inherited IRA or employer retirement plan. By contrast, says Miller, "If you name a charity as beneficiary, that charity will not have to pay any income tax."
While the charitable beneficiary can take tax-free distributions from a retirement account that has been bequeathed to it, human heirs can receive the appreciated assets at the owner's death and avoid or reduce income tax on a future sale.
"Neither the donor nor the charity will have to pay ordinary income tax on the retirement assets or their embedded gains," says Scott Michalek, principal and senior financial advisor at Wescott Financial Advisory Group in Philadelphia. "The heirs would receive personal investment assets that have no embedded tax liability in them, due to the step-up in cost basis at death." If the heirs want to sell those assets, says Michalek, they can do so free of tax consequences.
One way to implement such a plan is to use the IRA beneficiary form, saying that a set amount of money or a percentage of the balance will go to a specified charity or charities, while the rest passes to individuals.
"Leaving a percentage of an IRA to charity will not jeopardize the ability of other heirs to 'stretch' the distribution of the remaining IRA assets over their life expectancy," says Michalek. That enables the heirs to continue to take advantage of tax-deferred growth.
Michalek adds that the heirs should make sure that the charity's portion of the IRA is distributed by Sept. 30 of the year following the original account owner's year of death. Otherwise, the required distributions will be accelerated, and the heirs may lose a valuable tax deferral.
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.