Charitable Planning for Tax-Favored Retirement Accumulations

By Andrew J. Fair and Melvin L. Maisel.

In Brief

Integrating Charitable Planning While Maximizing Benefits

Charitable planning for tax-favored retirement accumulations requires careful consideration of estate tax status and minimum distribution requirements to avoid unintended adverse income and estate tax consequences to the owner and heirs. The owner’s charitable intentions and heirs’ needs for assured income are critical considerations. The amount of planning flexibility will also depend on whether the owner dies before or after the required beginning date. The authors present a number of planning scenarios and discuss alternative techniques—such as disclaiming a portion of the funds and utilizing life insurance proceeds—that will assure that the charity, the account owner, and any other heirs benefit according to the owner’s wishes.

Distribution planning for funds held in qualified retirement plans, IRAs, and tax-sheltered 403(b) annuity contracts (collectively known as tax-favored retirement accumulations) is one of the most active areas for financial and estate planners. Most of this planning does not directly involve charitable giving, because it is directed principally toward income tax deferral and wealth preservation for the heirs of high-net-worth individuals. Many financial and estate planners are unaware of the pitfalls to avoid when a charity is the intended recipient of tax-favored retirement accumulations, resulting in unintended adverse income and estate tax consequences to the owner and heirs.

To complicate matters, charities themselves exhibit a lack of understanding through promotional material urging potential donors to select them as beneficiaries of tax-favored retirement accumulations. Acting on such recommendations can adversely affect the owner and other beneficiaries.

Proper planning can maximize benefits for the owner and heirs of tax-favored retirement accumulations while assuring the charity will receive generous support.

Distribution Period

Distribution planning is governed by the provisions of IRC sections 401(a)(9) (regarding qualified plans) and 408 (regarding individual retirement accounts). Those sections, along with IRS regulations, describe the rules for distribution of tax-favored retirement accumulations. The rules provide that the distribution of such accumulations from the account of an individual who dies before the required beginning date (RBD) must be determined by using the life expectancy of the beneficiary. The RBD for most individuals is April 1 of the calendar year following the year they reach age 70Aw. Exceptions exist for qualified plan participants that 1) made a “TEFRA” or “242(b)(2)” election permitting a delay in commencement of benefits or 2) own no more than 5% of the company sponsoring the plan.

If death occurs before the RBD, any beneficiary can withdraw the funds at any time during the five calendar years following the owner’s death. A designated beneficiary (an individual or a qualified trust) can, by withdrawing a minimum amount in the year following the owner’s death, extend the distribution period over the beneficiary’s life expectancy. If an individual reaches the RBD, the distribution period is determined by the joint life expectancy of the owner and the designated beneficiary.

IRS regulations provide that certain entities—nonqualifying trusts, the owner’s estate, and charities—do not have a life expectancy. As a result, the designation of a charity as beneficiary for tax-favored retirement accumulations can have an adverse income tax impact on the owner and beneficiaries because the entire amount of the tax-deferred accumulations becomes income with respect of a decedent to the estate.

Death Before RBD: Charity as Sole Beneficiary

If the owner of tax-favored retirement accumulations dies before the RBD and a charity (or a number of charities) is the sole beneficiary, there will be no tax problem. Because the charity is the direct beneficiary of the funds, the estate tax charitable deduction will avoid any estate tax on the funds. Because the beneficiary pays the income tax on distributions of tax-favored retirement accumulations and the charity is exempt from income tax, none will be imposed and the charity will have full use of all of the funds. Because a surviving spouse has an absolute right to part of a qualified retirement plan participant’s benefits, spousal consent must be obtained when a charity is to be the sole beneficiary in order for the charity to receive the intended amount.

A charity receives the entire tax-favored retirement accumulation if it is the direct beneficiary, but the same would not be true if the decedent’s will directs payment of the funds to a charity and the beneficiary designation provides that the estate is to receive the funds. The estate tax charitable deduction will still be available, since the charity is the ultimate beneficiary of the assets. Even though the will mandates that the funds be paid to the charity, there is no income tax exemption since the beneficiary of the tax-favored retirement accumulations is the estate, which is not exempt from income tax. As a result, the designation of the estate as beneficiary of tax-favored retirement accumulations that the will directs to charity will reduce the amount available to either the charity or the heirs, depending upon the terms of the will, by the income tax that the estate must pay on such funds.

Death Before RBD: Multiple Beneficiaries

Some individuals elect to have part of their tax-favored retirement accumulations paid to a charity and the balance paid to their heirs, a bequest that requires great care in planning to avoid significant adverse income tax consequences to the noncharity beneficiaries.

IRS regulations provide that the distribution period for tax-favored retirement accumulations with multiple designated beneficiaries is determined by the beneficiary with the shortest life expectancy. If a charity is one of a number of beneficiaries, the distributions upon the owner’s death will be based on the charity, which has no life expectancy, forcing the other beneficiaries to withdraw their share within five calendar years.

For example, assume an individual with a $1 million IRA designates a 40-year-old child as beneficiary of half the account and a charity as beneficiary of the balance. The individual dies before the RBD. Because the charity is one of the beneficiaries, the period over which the child can withdraw the funds is limited to five years instead of her life expectancy, 42.5 years.

If the child delays the withdrawal until the end of the five-year period and the investment earns 8%, the child will withdraw $734,500, which is subject to income tax. If the child took the minimum withdrawal over her life expectancy, the total, assuming the same 8% return, would have been $4,302,255.

The loss can be avoided by establishing separate accounts, one for the charity and one for the child. The IRS has stated in the temporary income tax regulations (Proposed Regulations section 1.408-8) that each separate account can be distributed over the life expectancy of its beneficiary, giving a child the flexibility of making withdrawals over a longer period of time.

The multiple beneficiary concern is not as great when a spouse is the noncharity beneficiary. Since a spouse is permitted to roll funds received as a beneficiary to her own IRA, income tax deferral would remain available.

Death Before RBD: Trust as Beneficiary

There are special concerns when a trust (other than a charitable remainder or lead trust) is a beneficiary of tax-favored retirement accumulations. It is not uncommon for an individual to create a trust for the benefit of a spouse or children with a charitable remainderman that does not qualify as a charitable remainder trust because there are discretionary distributions of income or principal available to the beneficiary. For example, many people use qualified terminable interest property trusts (QTIP) as beneficiaries of tax-favored retirement accumulations. The marital deduction is available, allowing more funds to be available to the spouse. The trustee is permitted to distribute principal to satisfy the spouse’s needs, providing more protection than a charitable remainder trust. Control of the ultimate disposition of the funds is available with a QTIP, because the trust determines how the funds are distributed upon the spouse’s death. But if a charity is the remainderman, the planning will have a devastating negative effect on the money available to the spouse.

When a qualifying trust is the beneficiary of tax-favored retirement accumulations, distributions must be made over the life expectancy of the trust beneficiary with the shortest life expectancy. A qualifying trust is one that is irrevocable or becomes irrevocable upon the owner’s death, has an identifiable class of beneficiaries, and is valid under state law (except for any corpus requirement). A copy of the trust or information about the trust beneficiaries must also be provided to the plan administrator or IRA custodian.

If a qualifying trust is established for the benefit of children, upon the owner’s death, the trustee can withdraw the funds over the life expectancy of the oldest child. As a general rule, contingent beneficiaries are not taken into account unless there is a significant possibility they will actually receive benefits from the trust.

In almost all instances, contingent beneficiaries are younger than the primary beneficiary. The beneficiary with the shortest life expectancy under a trust providing income to a spouse with the remainder to the children will almost certainly be the spouse (especially if the spouse is their parent). The same is true of a generation-skipping trust that provides income to the children and the remainder to the grandchildren. But when a charity is entitled to the remainder, IRS rulings have had disastrous consequences for the spouse.

PLR 9820021 involved a QTIP trust that was the beneficiary of an IRA. Under the terms of the trust, the spouse received all of the income and had a right to principal distributions, based on the trustee’s discretion. Upon the spouse’s death, any amounts remaining in the trust were to be paid to a charity.

Because the trust qualified as a QTIP trust, no estate tax was imposed when the IRA owner died. No estate tax would be imposed when the spouse died because the charity was the remainder beneficiary. However, the IRS concluded that even though the spouse had access to the principal at the trustee’s discretion, it was almost certain that the charity would receive a benefit from the trust. As a result, the IRA had to be distributed to the trust and subjected to income tax within five years of the owner’s death. The income tax significantly reduced the amount available to the spouse and the amount remaining upon the spouse’s death for the benefit of the charity.

Death After RBD: Charity as Sole Beneficiary

Charitable planning for tax-favored retirement accumulations is significantly more complicated after the owner reaches the RBD. The distribution period, determined by the joint life expectancy of the owner and the beneficiary, is irrevocable after the RBD. When a charity is the beneficiary, distributions must be made over the life expectancy of the owner alone. This significantly accelerates the income tax liability, especially if the owner has other assets and would normally only withdraw the minimum.

For example, the life expectancy of a single 70-year-old is 16 years. The joint life expectancy of a 70-year-old and a 67-year-old is 22 years. An individual with a 67-year-old spouse who designates a charity as beneficiary must withdraw in the first year one sixteenth of the account instead of one twenty-second. Each subsequent year during the owner’s lifetime, the required withdrawal will be significantly greater than would be the case if the spouse were the beneficiary. The one advantage is that the owner can be certain that the charity will receive the funds when the owner dies.

If an individual intends to benefit a charity with tax-favored retirement accumulations and has no personal need for the funds, the entire account can be withdrawn and gifted to a charity. The charitable deduction will offset the income recognized in the year of withdrawal provided a full charitable deduction is available for that year. If a full charitable deduction is not available, withdrawals over a period of years can be used.

It is also possible for the owner to withdraw over the single life distribution period and make a charitable gift each year of the amount withdrawn. The charitable deduction will in most instances offset the income from the withdrawal and the owner will retain access to the funds during her lifetime. If this approach were utilized, the recalculation method for determining life expectancy would normally be elected, permitting the owner to withdraw lesser amounts each year.

Disclaimer Planning: Spouse

The simplest way to avoid accelerated distribution of inherited funds is through disclaimer planning. Under this approach, the spouse is designated as the primary beneficiary and a charity, the contingent beneficiary. The owner can then withdraw the funds over the joint life expectancy of the owner and the spouse, reducing the minimum required withdrawal.

When the owner dies, the spouse can roll over the funds into the spouse’s own IRA or disclaim all or any part of the amount, which will then pass to the charity without income or estate tax. The spouse has the right to disclaim for a period of nine months after the owner’s death. This disclaimer technique does require special planning against the contingency of a common disaster or the inability of the spouse to disclaim.

The common disaster contingency can be addressed by a presumption that the spouse predeceased the owner. Most state laws automatically consider this presumption, but there is no reason not to include it in the beneficiary designation.

The concern is greater if the spouse is unable to disclaim. For example, if the owner and spouse are in an accident and the owner dies and the spouse is in a coma, the spouse would be unable to make the disclaimer. The spouse could execute a springing limited power of attorney, which would give its holder the ability to disclaim the benefit for the spouse provided the owner was dead and the spouse was unable to act. Obviously, the power of attorney would have to be given to someone likely to make the disclaimer; another inheritor might be a poor choice.

As additional protection, the beneficiary designation could provide that the benefit is payable only if the spouse survives the owner by at least six months. The law allows a marital deduction even if a six-month survival contingency is included, and this would protect the charitable planning if the spouse dies within the six-month period. If the spouse predeceases the owner, the charity, as contingent beneficiary, would be entitled to the funds.

Disclaimer Planning: Children

Disclaimer planning can also be used when the owner has no spouse but has other beneficiaries that can be trusted. For example, a child can be designated as the beneficiary at the RBD, permitting the owner to withdraw benefits over a period determined under a procedure known as the minimum distribution incidental benefit rule. This rule requires that the measuring period for an individual whose beneficiary is more than 10 years younger and not a spouse be based on the joint life expectancy of the owner and an individual 10 years younger. As with a spousal beneficiary, the disclaimer must be made within nine months of the owner’s death and can consist of any portion of the benefit.

Death After RBD: Multiple Beneficiaries

At the RBD, selecting multiple beneficiaries where one or more of which is a charity will adversely impact both the account owner and the noncharity beneficiaries. Since the charity has no life expectancy, the owner is required to withdraw the accumulated funds over her life expectancy alone, significantly increasing the minimum withdrawal while the owner is alive.

If the term certain method is chosen, upon the owner’s death all beneficiaries can withdraw over the balance of the owner’s life expectancy measured as of the required beginning date. If the recalculation method is chosen, the beneficiaries will be required to withdraw their share in full during the year following the owner’s death. In either case, the beneficiaries will be forced to withdraw more rapidly than if their life expectancies had been factored into the determination of the distribution period. < p> When a charity is intended as beneficiary of only part of the tax-favored retirement accumulations, the most efficient planning method is to divide the accumulations into separate accounts. Assuming the funds are held in an IRA, the amount payable to a charity can be held in one IRA and the balance held in another. < p> For example, an individual with an IRA worth $2 million planning to pass $1 million to a charity upon death and the balance to her children can establish two IRAs, each initially worth $1 million. The individual designates the charity as the beneficiary of one IRA and the children, the other.

The minimum required distribution from the IRA payable to the charity would be based on the owner’s life alone, whereas the minimum required distribution from the IRA payable to the children would be based on the minimum distribution incidental benefit rule. The law permits an IRA owner to withdraw the minimum required distribution for all IRAs from any specific IRA. To keep the amount payable to the charity at $1 million, the owner can withdraw from that IRA the necessary amounts and draw any remaining minimum distribution required from the IRA payable to the children.

The calculation follows:

Charitable Remainder Trust

The charitable remainder trust is a vehicle that permits individual beneficiaries to receive income from an amount transferred to a trust and makes a charity the remainderman when the income payments cease. The income can be paid to a beneficiary for a fixed period of time (not in excess of 20 years) or, if longer, for life.

Assume an IRA owner wants to assure a spouse income while alive and also wants to assure that a charity will receive the principal when the spouse dies. The IRA owner designates a charitable remainder trust as beneficiary of the IRA account. The trust provides that the spouse is to receive income at the rate of 8% per year for life, with the amount remaining upon the spouse’s death passing to a charity.

Because a charity is the remainderman, the value of the remainder interest is not included in the owner’s estate because of the estate tax charitable deduction. The trust qualifies as a QTIP trust, because all of the income is payable to the spouse. As a result, no estate tax is imposed on the IRA funds that are transferred to the charitable remainder trust, the spouse receives income for life, and the charity receives the principal when the spouse dies. This approach permits the spouse to receive income based on the full value of the IRA. Contrast this with the case discussed earlier, PLR 9820021, which provided that a QTIP trust was the beneficiary of an IRA. The charitable remainder trust technique permits the spouse to receive income from the full value of the IRA, since no income tax is imposed when the IRA is paid over to the trust. When a charitable remainder trust is used, the beneficiary designation can provide that the charity is the direct beneficiary of the IRA if the spouse predeceases the owner.

Of course, the downside is that the spouse has no access to the principal when a charitable remainder trust is used.

A charitable remainder trust can be used with nonspouse income beneficiaries as well. For example, the trust can provide that income is payable to the spouse for life, and continues to be paid to the children for the balance of their lives. If the income beneficiary is not a spouse, however, the estate tax charitable deduction at the owner’s death is limited to the present value of the remainder interest.

Charitable planning is especially useful for funds remaining in a qualified plan at a participant’s death, especially if a spouse does not survive the participant. Only the participant and spouse can roll over funds from a qualified plan to an IRA. If benefits under a plan are payable to a nonspouse beneficiary, distributions from a qualified retirement plan can only continue as long as the plan continues to exist. The termination of the plan will require distribution and taxation of the entire principal, leaving the beneficiaries only the after-tax value of the funds from which to draw income. Designating a charitable remainder trust as beneficiary will provide potentially greater benefits to a nonspouse beneficiary, because the income stream will be based on the entire principal amount. Of course, that principal will belong to the charity when the income beneficiaries die.

Life Insurance Planning

Charitable planning for tax-favored retirement accumulations can be very effective when combined with life insurance planning. Life insurance proceeds can be used either to enhance the amounts available to the charity or to replace the amount passing from the IRA to a charity.

When a charity is the beneficiary of qualified retirement plan benefits, the accumulated funds will not be available to family members. The income and estate tax are avoided on the qualified retirement plan benefits only to the extent that the benefits are payable to the charity. If the benefits are payable to the heirs, they will receive the after-tax value of the benefits, including the deferral opportunity. That after-tax value, plus the value of the deferral opportunity lost to the heirs, can be replaced with life insurance.

If part of the qualified retirement plan funds are invested in a life insurance policy whose proceeds are payable to the heirs, the charity and family can both benefit. Because the death benefit is provided through life insurance, the proceeds will not be subject to income tax to the extent of the pure amount at risk under the policy. The pure amount at risk is the difference between the life insurance proceeds and the policy cash value as measured immediately before death. The taxable cash value is reduced by the basis in the policy, including the cumulative or yearly renewable term amounts attributed to employees. If the spouse is the beneficiary, he or she can roll the taxable amount to a spousal IRA. With proper planning, the life insurance proceeds may be excluded from the participant’s taxable estate, further enhancing the benefit for the heirs.

Andrew J. Fair, Esq., is a partner in the law firm of Fair, Aufsesser & FitzGerald, P.C., White Plains, N.Y.
Melvin L. Maisel is chair of Cornerstone Bank, Stamford, Conn., and president/CEO of Stabilization Plans for Business, Inc., White Plains and Greenwich, Conn.

Copyright © Sep-tember 2000, Andrew J. Fair and Melvin L. Maisel.

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