How IRAs Benefit You, Loved Ones, & Charity

There are many ways an IRA can benefit you, your loved ones, and charity. In fact, charitable strategies might leave every-one better off than traditional IRA strategies.

These strategies are appropriate for traditional IRAs, not the tax-free Roth IRAs. I’m also not talking about the $100,000 IRA charitable contribution law that has moved in and out of the tax law in recent years. (Currently, the provision expired at the end of 2014, but there’s a chance it will be reinstated retroactively for 2015 contributions. The problem is we can’t count on that.)

One advantage of these charitable strategies is they can keep your kids from messing up plans for your IRA. It’s not unusual for parents to spend a fair amount of time structuring an IRA inheritance to maximize the after-tax benefits and deferral to their children. Then, after inheriting the IRA, the children mess up all that planning by taking the money out quickly, paying the income taxes, and spending the rest. You might be able to prevent that and still provide substantial benefits to your children.

Another advantage is these strategies can help reduce the problems required minimum distributions cause many people. For a number of people in their late 70s and older, the RMDs increase each year and exceed what they need for spending. The result is higher income taxes and the loss of deferral.

A third potential advantage is the strategies won’t be affected by the proposals to end or curtail Stretch IRAs. The President introduced such proposals in recent budgets, and some members of Congress also favor the change. If you’re worried about such proposals becoming law and want to be in front of things, consider charitable IRA strategies.

Charity as IRA beneficiary. The simplest strategy is to make charitable gifts in your estate through an IRA. You can set up a separate IRA that has roughly the amount you want the charity to receive, and name the charity as the beneficiary. Or you can name the charity as one of several beneficiaries for an IRA, noting either the dollar amount or the percentage of the IRA you want the charity to receive.

After you pass, the charity takes a distribution of its share of the IRA. Since the charity is tax-exempt, it doesn’t owe any income taxes and receives the full benefit of the distribution.

When your children or other loved ones inherit an IRA, they include the distributions in gross income and owe income taxes on them. They really inherit only the after-tax value. But when they inherit non-IRA assets, they increase the tax basis to the current fair market value. They can sell the assets right away and won’t owe any capital gains taxes on the appreciation that occurred while you owned the property.

If you’re going to make a straightforward charitable contribution through your estate, it’s better to make them through an IRA than the rest of the estate.

Charitable remainder trust. There are at least two ways to combine an IRA with a charitable remainder trust (CRT).

The first strategy provides long-term in-come for your loved ones and prevents them from spending down the assets too quickly. Your estate planner drafts a CRT, usually as part of your will and called a testamentary CRT. (The charity or charities you wish to benefit might have legal forms available.) On the beneficiary designation form for the IRA, you name the CRT as the beneficiary. After you pass, the entire IRA is distributed to the CRT.

The CRT then pays income to a beneficiary or beneficiaries you named in the trust. A typical provision is for the CRT to pay a percentage of the trust assets to the beneficiary for life. The annual payouts rise and fall with the value of the trust. An alternative is for the trust to pay a fixed annual amount to the beneficiary. IRS regulations limit the amount of income that can be paid to the beneficiary. After the beneficiary passes away, the remainder of the trust is donated to the charity.

If your estate planner runs the numbers, they should show that your beneficiary receives more after-tax money under the CRT than if the IRA is liquidated either shortly after it was inherited or within five years. The beneficiary receives a little more lifetime after-tax money if he or she had stretched distributions over life expectancy and managed the investments as well as the trust. But the purposes of the trust are to ensure the beneficiary doesn’t spend too quickly and also to benefit the charity.

A CRT also can be used during your lifetime to avoid RMD problems and generate lifetime income. You can take a distribution of all or a large portion of the IRA. That amount is included in your gross income. You immediately transfer all or most of the distribution to a CRT. The CRT is set up to pay annual income to you (or you and your spouse) for life. After that, the remainder goes to the charity. As an alternative, you can have the CRT pay income to your children or grandchildren if you don’t need the income.

When you contribute money to the CRT, you receive a charitable contribution deduction. The deduction isn’t equal to the full value of the contribution. Instead, the deduction is the present value of the amount the charity is expected to receive. Current interest rates and tables issued by the IRS are used to determine the deduction. The older you are, the larger the percentage of the contribution you can deduct.

The strategy should significantly reduce the taxes owed on the IRA Distribution and your lifetime taxes on the IRA money. It also ensures you have lifetime income and that charity receives a contribution.

Most large charities have offices that will manage and administer a CRT for little or no money when they are a beneficiary of the CRT.

The life insurance twist. This strategy can ensure that your loved ones and a charity receive the full after-tax value of your IRA or more. It is for someone who doesn’t really need the IRA to pay for retirement spending and wants to ensure the maximum after-tax value can pass to others.

First, name your spouse as the primary beneficiary of the IRA and charity as the contingent beneficiary. You can name a donor-advised trust as the charitable beneficiary so that you don’t have to determine the charities now.

Then, you acquire a permanent life insurance policy. It usually is best to obtain a joint and survivor policy issued to you and your spouse with the policy benefit equal to the current value of the IRA. The policy should be owned by an irrevocable life insurance trust.  You can use distributions from the IRA to pay the premiums, either RMDs or regular distributions. The trust benefits your children, and perhaps the grandchildren.

Here’s an example of how the strategy can work.

Max Profits is 71 and his wife Rosie is 65. Max has a $2 million traditional IRA, and his first RMD will be about $73,000. He doesn’t need that income to fund his expenses.

Max and Rosie obtain a joint and survivor life insurance policy with a benefit of $2 million for an annual premium of $25,213. They establish a life insurance trust to be the beneficiary and owner of the policy, with their three children and four grandchildren as future beneficiaries of the trust.

Max changes his IRA designation form so that Rosie still is the primary beneficiary but a donor-advised fund is the contingent or secondary beneficiary.

During Max’s lifetime, he takes RMDs from the IRA and contributes a portion of them to the trust to pay the insurance premiums. These should qualify as tax-free gifts under the annual gift tax exclusion. After Max passes away, the IRA is available to Rosie for income and to make gifts to the trust to pay insurance premiums.

After Rosie passes away, the remaining value of the IRA goes to the donor-advised fund. There are no taxes on this transfer. The children and grandchildren then can serve as directors of the fund and make charitable gifts from the fund over the years.

Also after Rosie’s passing, the life insurance policy pays $2 million to the insurance trust, and the trust makes income and principal distributions to the children and grandchildren according to the terms Max and Rosie set when they created the trust. The life insurance proceeds avoid all income and estate taxes for both the trust and the beneficiaries.

The result is that the children and grandchildren receive the IRA’s full initial value without any reduction by taxes, RMDs, or poor investment returns. Max and Rosie both have access to the IRA during their lifetimes. The remainder of the IRA goes to the charitable fund set up by Max and Rosie, and their children and grandchildren oversee it. Because of the leverage in the insurance policy and the lack of taxes, there is more money available than before, so all these goals can be met.

A number of variations in the details are possible. For example, instead of naming Rosie as the sole initial beneficiary of the IRA, a charitable trust could be the beneficiary. It would pay Rosie a lifetime income, and any remainder would go to the foundation or other charities. Or after Max’s passing the IRA could buy an annuity payable to Rosie for life.

RW November 2015.