PERSONAL FINANCIAL PLANNING

GIFTING IRC SECTION 403(b) ASSETS

By Mitchell J. Smilowitz

What happens when a participant in a 403(b) plan wishes to donate the assets in the account to his tax-exempt employer? IRC section 403(b) provides for defined contribution retirement arrangements available exclusively for certain not-for-profit institutions. Only public educational systems and tax-exempt organizations described under IRC section 501(c)(3), such as charitable, educational, or religious organizations, may sponsor 403(b) programs. These arrangements, commonly called tax-sheltered annuities (TSAs) or tax-deferred annuities (TDAs), qualify for preferential tax treatment whereby contributions are made on a pretax basis and earnings accumulate tax deferred. Both elective deferrals, through salary reduction contributions and matching employer contributions (i.e., nonsalary reduction contributions) are permitted, within statutory limitations, to fund 403(b) retirement benefits.

Say a professor on the faculty of a medical school who has accumulated over $1 million in retirement assets in a 403(b) plan wishes to gift the assets to his tax-exempt IRC section 501(c)(3) employer. How can the gift be structured so as to maximize the tax benefit to the participant-donor and the charitable benefit to the tax-exempt donee employer? Specifically, there are three possible methods:

* The participant names the employer as a beneficiary of the TDA account;

* The participant commences distributions (in accordance with tax law and plan provisions) and makes income tax deductible charitable contributions to the employer; or

* The participant commences distributions (in accordance with tax law and plan provisions) and gifts the assets to a charitable trust.

Participant Names Institution as Beneficiary of the TDA Account

The easiest way to donate the assets is for the participant to name the tax-exempt employer as the designated beneficiary of the account. The primary advantage here is that no income tax liability would be imposed on the participant. (Normally, a distribution from a retirement plan is taxable as ordinary income.) Moreover, IRC section 2055(a) provides that the donation reduces the participant's gross estate and, accordingly, the potential estate tax liability. Because the recipient institution is a tax-exempt organization, no tax liability would be imposed on the employer either.

The disadvantages of this method are borne primarily by the recipient institution. The institution must wait until the participant's death to receive the donation, thus delaying receipt of the funds and use of the assets. What may be more troubling to the institution is that, during the waiting period, the beneficiary designation may be revoked at any time prior to the participant's death. In addition, if the 403(b) plan is subject to the provisions of the Employee Retirement Income Security Act of 1974 (ERISA), as amended, the necessary spousal consent waivers must be obtained if the participant is married and chooses to name someone other than the spouse as a primary beneficiary for more than 50% of the retirement benefit.

Participant Begins Distributions and Makes a Charitable Contribution

The participant may decide to commence distributions, in accordance with tax law and plan provisions, and make annual income tax deductible charitable contributions to the institution as an outright gift.

One advantage of this option is that the institution receives the donation during the current and subsequent years, rather than waiting for the death of the account owner. To the taxpayer-participant, a major advantage is that no gift tax liability would be incurred since, under IRC section 2522(a), a donor is permitted to make unlimited charitable contributions to a qualified charity, such as a 501(c)(3) organization. In addition, any future income and earnings on the gift inure to the benefit of the institution and are removed from the taxpayer's estate.

There are several disadvantages, however, to the participant-donor method. First of all, distributions of TSA assets to the participant generate taxable income, which would be offset only partially by a charitable contribution income tax deduction. IRC section 170(b)(1)(A) limits the deduction for all charitable contributions made during the tax year to 50% of the taxpayer's annual adjusted gross income (AGI). Charitable contributions not deductible as a result of exceeding the AGI limit may be carried over for up to five years. Also, it is likely that the recipient-institution qualifies as a 50% limit organization. Another problem is that the annual limitation on the charitable contribution deduction may affect the taxpayer-participant's ability to make deductible contributions to other charities. Finally, itemized deductions, reported on Schedule A of Form 1040, are subject to an overall limit when the taxpayer's AGI exceeds an annual threshold (i.e., $126,600 for married taxpayers filing jointly--$63,300 for married taxpayers filing separately--in 1999. For instance, certain itemized deductions, including charitable contributions, may be reduced by up to 3% of the amount of AGI in excess of the annual threshold.

Participant Begins Distributions and Gifts the Assets to a Charitable Trust

The participant-taxpayer could commence distributions, in accordance with tax law and plan provisions, and gift the assets to a charitable trust. For instance, under a charitable remainder trust (CRT), annual payments are made to the donor or the donor's family (the non-charitable income beneficiaries) with the remainder interest payable to the charity (in this case, the tax-exempt employer). This would permit the participant, or family members, to reap some of the retirement benefits yet still provide a substantial bequest. The participant-donor can take a charitable contribution income tax deduction, on Form 1040, for the gift. The deduction is measured by the present value of the ultimate gift to the charity and is subject to the 50% limitation rules. Again, no gift tax liability would be imposed on the charitable institution.

IRC section 664(d) provides that gifts of a remainder interest, however, only are deductible under a charitable remainder annuity trust (CRAT), a charitable remainder unitrust (CRUT), or, as provided under IRC section 642(c), a pooled income trust.

In a CRAT, a fixed amount or a fixed percentage of the initial value of the trust is distributed annually to the non-charitable beneficiaries, whereas in a CRUT a fixed percentage of the annual value of the trust is distributed each year to the non-charitable beneficiaries. In a pooled income trust, also known as a pooled income fund, the donated property is commingled with property transferred by other donors, and the non-charitable income beneficiaries receive a pro rata share of the income from the trust each year. A tax deduction also is available under IRC section 170(f) for a charitable lead trust (CLT), where the trust income is distributed annually to the charity with the remainder interest reverting to the donor or the donor's family when the trust terminates. Whichever charitable trust is chosen, however, the trust is irrevocable and cannot be altered, invaded, or amended. Accordingly, gifting assets to the trust is advantageous to the charity because the beneficiary election cannot be changed.

The disadvantages of this option are that, again, the distribution to the participant is taxable and the deduction for charitable contributions and itemized deductions by the participant-donor may be limited each year. Also, there are additional expenses that will be incurred: attorney fees to draft the trust instrument and annual administrative expenses for administering the trust. In addition, for CRTs, the charity must wait until the death of the income beneficiaries or termination of the trust before receiving the donation; for CLTs, the charity only receives annual income payments for the term of the trust but not the trust corpus. Finally, additional donations cannot be made to a CRAT, although additional donations can be gifted to a CRUT.

Other Applications

Although this article addresses the options available for gifting assets in a 403(b) plan, in general, these options would also be applicable to a participant in a 401(k) plan who wishes to donate the assets in the account to a tax-exempt charitable organization. *

Mitchell J. Smilowitz, CPA, is a benefits consultant with GBS Retirement Services, Inc., a subsidiary of Arthur J. Gallagher and Co.

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA/PFS

Contributing Editors:
Alan J. Straus, CPA

David R. Marcus, CPA
Paneth, Haber & Zimmerman LLP

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