26 February 2016

Charitable Contributions of Retirement Plan Benefits

Each year Americans give billions of dollars to charity. Gifting an interest in a defined contribution plan or IRA to a charity can be a very effective tax strategy for making charitable gifts. (Note: This discussion does not apply to Roth IRAs; they are subject to a different set of rules.)

Special Rule for IRAs

IRA owners over age 70-1/2 may direct that up to $100,000 of their IRA be distributed directly each year to certain types of charity. This is called a qualified charitable distribution (“QCD”).
The IRA beneficiary does not include the QCD in income. The charity pays no tax on the distribution since it is tax exempt. Also, a QCD counts toward the annual required minimum distribution that an IRA beneficiary must make from his or her IRA once he or she is 70-1/2 years old.

In contrast to a QCD, an IRA owner can take distributions from his or her IRA and contribute the proceeds to charity. However, a QCD may result in less tax than taking distributions from an IRA and contributing them to charity. A beneficiary has taxable income when he or she takes a distribution from an IRA. The beneficiary then receives a charitable contribution deduction on the contribution to a charity.

For several reasons, the income realized on the distribution and the deduction on the contribution do not always offset:

  • the IRA beneficiary may have larger charitable contributions than are allowed as a deduction in one year;
  • the IRA beneficiary must claim itemized deductions rather than take the standard deduction to take a charitable contribution deduction;
  • if the IRA beneficiary has adjusted gross income over a certain threshold ($311,300 in 2016 for a joint return), itemized deductions (including the charitable contribution deduction) are reduced. As a result, the charitable contribution deduction is less than the IRA distribution included in income.
An example would be the floor for medical expense deductions. In addition, the income from an IRA distribution will reduce deductions or credits that are based on Adjusted Gross Income.

The IRA beneficiary should consider whether a QCD is the most efficient way to fund a charitable contribution. If a QCD makes sense, the beneficiary must arrange for the IRA trustee to make the distribution directly to the charity.


Other Charitable Contribution Alternatives

As noted in an earlier post, a defined contribution plan or IRA beneficiary typically cannot assign his or her retirement benefits account prior to death. However, the beneficiary generally may decide where the interest in the retirement account goes on his or her death.

If a person wants to leave some of his or her estate to charity and some to a noncharitable beneficiary, the most tax efficient allocation of assets generally is to fund the charitable gifts with retirement benefits and leave the other assets to the noncharitable beneficiaries. Retirement plan assets are worth more to a charity than to individual beneficiaries, while other types of assets are worth the same to a charity and to an individual.

If someone inherits an interest in a qualified defined contribution plan, he or she must pay income tax on distributions from the retirement plan. The income tax reduces the value of the inherited benefits. Since a charity is tax-exempt, it does not have to pay tax on the distributions from the retirement plan. The income tax does not reduce the value of the retirement benefit.

In contrast to retirement benefits, most other types of inherited assets do not come with an income tax cost, even for a noncharitable beneficiary, because of two income tax rules:
  1. An inheritance is not income. When someone inherits cash, retirement benefits or other assets, he or she does not owe any income tax on the value of the inheritance. Income tax liability, if any, will arise only when the recipient sells the inherited asset or (in the case of an inherited retirement plan) withdraws funds from the plan.
  2. Most assets, including real estate, stocks and bonds, receive a new basis for income tax purposes when they pass from a decedent to an heir. The new basis is equal to the fair market value of the property on the date of the decedent’s death. As a result of this new basis, the beneficiary pays no income tax on any gain that built-up in the assets prior to the time that he inherited them. In contrast, a retirement plan does not get a new basis at death.

An example helps illustrate these principles. Assume David’s mother dies leaving David a stock portfolio worth $500,000 and an IRA worth $500,000. David’s mother had a $100,000 basis in the stock portfolio. There is no estate tax because the estate is under the available federal estate tax exemption. The stock portfolio is transferred to David. There is no income tax due since an inheritance does not generate taxable income. The IRA is registered in David’s name as beneficiary of his mother, but David does not take a distribution from the IRA. As a result, he has no income tax.

Now David sells the stocks for $500,000 and withdraws $500,000 from the IRA.

David pays no income tax on the stock sale. His basis in the stock is $500,000 (date of death value), so there is no taxable gain. The $400,000 gain that built-up during David’s mother’s life is never taxed because of the new-basis-at-death-rule.

David does have taxable income as a result of the IRA distribution. He will have $500,000 of ordinary income on which he will have to pay tax. At the top individual income tax rate, the tax would be $198,000.

Assume David’s mother wanted to give one-half of her estate to David and one-half to a charity. She could (1) leave one-half of each asset to each beneficiary; (2) leave the IRA to David and the stock portfolio to the charity; or (3) leave the stock portfolio to David and the IRA to the charity.

The charity is indifferent as to the asset that it receives. Whether the charity receives the IRA, the stock portfolio or one-half of each, the charity will receive $500,000 because it does not have to pay income tax.

For David, however, what he receives makes a difference. If he receives the IRA, he will have to pay income tax, which could be up to $198,000, when he withdraws the money. If David receives the stock, he can realize $500,000 without any tax costs.

An IRA beneficiary may wish to make a gift to charity on his or her death that is less than the retirement account balance. It is possible to give a charity part of a retirement account balance. However, the retirement plan beneficiary needs to be careful in how they make a gift of a partial interest to a charity. If the beneficiary designation is not done correctly, the non-charity beneficiaries could lose the tax benefit of stretching out distributions.

Feedback on Last Post on Employer Securities

Several people were kind enough to provide feedback on the last post. In that post, we discussed the tax treatment of unrealized appreciation in employer securities. We noted that a beneficiary could receive the securities in a distribution from a qualified defined contribution plan and pay tax based on what the plan paid for the securities. The beneficiary then has a basis in the securities equal to that amount. The unrealized appreciation in the securities is not taxed at the time of distribution.

As one person noted, the IRS takes the position that the basis of the securities does not step up to fair market value on the beneficiary’s death to the extent of the unrealized appreciation in the employer securities. As a result, the person who inherits the securities will have a long-term capital gain on a sale of the securities to the extent of the unrealized appreciation. This feature may lessen the tax benefits of an outright distribution of the securities compared to rolling the securities into an IRA.

Another point that several people made was that there must be substantial appreciation in the employer securities to justify taking the distribution into income currently rather than deferring distributions as long as possible. This is true. The bottom line is that there are many alternatives. Each person must do a calculation of the tax costs of the various alternatives to find what is best in that particular situation.

This post discusses general rules and is not specific legal or tax advice for you to rely on. Please consult a qualified advisor to discuss your specific situation.