According to data collected by the Investment Company Institute, Americans held $7.9 trillion in IRAs by the end of 2016, making IRAs the largest pool of individually held retirement-type assets in the U.S. This is up significantly from the $3.7 trillion of IRA assets held in 2008. With this growth, estates are increasingly comprised largely of IRAs and other retirement plans. Especially for professionals, business owners and employees, 30% to 80% of an estate could consist of IRAs or other retirement plans. As such, more and more IRA owners are seeking help and guidance from advisors in determining how to distribute IRA assets to family and charitable organizations while minimizing tax consequences.
This article will explain the basic rules surrounding IRAs and the tax implications for distributions to the IRA owner, to family and to charity. It will shed light on the IRA charitable rollover, discuss the primary options available when leaving an IRA to a spouse or child and provide charitable IRA solutions for philanthropic IRA owners. By understanding the options that are available, advisors can be better equipped to provide clients with options and tools that will ultimately accomplish the personal goals of the client and distribute assets in a tax-efficient manner.
IRA BASICS AND THE IRA CHARITABLE ROLLOVER
IRAs are attractive to taxpayers because they provide major benefits to the IRA owner during life. First, contributions to traditional IRAs are made on a pre-tax basis. Second, the funds held within the account grow tax free. However, distributions from IRAs are taxable at ordinary income rates. Once a traditional IRA owner reaches age 70½, he or she must begin taking a required minimum distribution (RMD) each year. The RMD is based on the life expectancy of the IRA owner and the account balance. As the IRA owner gets older, the percentage of the IRA that must be distributed increases. The RMD amount will increase the donor's adjusted gross income (AGI) and is taxed at ordinary income rates.
To avoid paying tax on the RMD and being pushed into a higher tax bracket, many IRA owners choose to take advantage of the IRA charitable rollover. The IRA charitable rollover, which was made permanent in 2015 with the passage of the Protecting Americans from Tax Hikes (PATH) Act, enables IRA owners over the age of 70½ to make direct transfers from their IRAs to public charities without being taxed on the distribution and without recognizing the distribution as income for tax purposes. Sec. 408(d).
This qualified charitable distribution (QCD) is allowed up to a total of $100,000 per year and may satisfy part, or all, of the owner's RMD. Note that, because the transfer is not included in taxable income, there is no charitable income tax deduction. However, it still carries the same economic impact and, thus, is a great option for those choosing not to itemize their taxes this year. By making a charitable rollover gift, a non-itemizer is essentially receiving the same benefits as a charitable deduction since the distribution will be excluded for tax purposes.
Susan is a faithful supporter of her favorite charity. She has a $200,000 IRA and her RMD this year is 5%, or $10,000. Because she has substantial other income and does not itemize her deductions, Susan directs her IRA custodian to make a qualified charitable distribution to her favorite charity in the amount of $10,000. Because the full RMD is transferred to a qualified charity, Susan will owe no taxes on her RMD and will not be required to include it in her income for tax purposes. Because Susan takes the standard deduction, the IRA rollover reduces her taxable income by $10,000. Based on her income tax rate of 32%, the IRA charitable rollover will save Susan $3,200 of income tax. After seeing the benefits of this tax-saving and charitable strategy, Susan plans to continue making IRA rollover gifts for the rest of her life.
BEQUEST OF IRA TO FAMILY MEMBERS
When an IRA owner passes away, the IRA is transferred according to the IRA beneficiary designation form. If the IRA owner passes away with the surviving spouse as the sole beneficiary, the surviving spouse can choose to roll over the inherited IRA into a new or existing IRA in the surviving spouse's name. If the surviving spouse has not yet reached age 70½, then he or she can delay distributions until age 70½ instead of being forced to continue to take the deceased IRA owner's RMDs. Note that, with this option, the traditional IRA rules apply. Therefore, the surviving spouse must begin taking distributions at age 70½ and could face penalties if a distribution is taken prior to the age of 59½. In addition, the surviving spouse's distributions will be fully taxable at ordinary income tax rates.
Spousal Inherited IRA
Another option for a surviving spouse is to receive distributions under the original IRA owner's plan as an inherited IRA. With this option, the surviving spouse will begin taking distributions right away. Thus, this option may be attractive for a surviving spouse who is under age 59½ and needs to access the IRA funds immediately, since the surviving spouse will not be subject to an early withdrawal penalty under this method. If the deceased IRA owner had not reached the age of 70½ when he or she passed away, then the surviving spouse can choose to delay taking distributions until the date after which the deceased IRA owner would have reached age 70½.
IRA to Children
If an IRA owner is unmarried or survives his or her spouse, often the first instinct is to designate children as beneficiaries. Unfortunately, this carries negative consequences because the children will be required to pay tax on the value received. If the IRA owner died prior to age 70½, then the children can either choose to take out the entire amount of the IRA within a five-year period or to "stretch" out the distributions over the children's life expectancy as an inherited IRA.
If the IRA owner was 70½ or older at the time of death, the default is for the distributions to continue to the children under the deceased IRA owner's original RMD schedule. Alternatively, the children can elect the stretch method described above.
Regardless of the option selected, the children will have to pay ordinary income tax on the entire distribution amount received. This greatly diminishes the inheritance amount that is ultimately passed on to children.
Richard, age 80, designates his daughter Linda as beneficiary of his IRA. When Richard passes away, Linda is 59 years old and decides to stretch out the distributions from the IRA using the IRS's "Single Life Expectancy Table" to calculate her own RMD. The balance of the IRA in the year that Richard passes away is $500,000. Linda will begin receiving distributions the following year. The distributions will be calculated based on her life expectancy of 25.2 years under the Single Life Table. Linda's first distribution will be equal to $500,000 divided by 25.2, or $19,841. With her federal income tax rate of 32%, Linda will owe $6,349 of tax on the distribution, thereby reducing the distribution to $13,492 after tax. Each year, Linda's distributions will increase. After 26 years, the account will be fully distributed.
IRA CHARITABLE STRATEGIES
Benefiting Children and CharityIRA Testamentary Unitrust
IRA owners who want to use their IRAs to benefit both their children and their favorite charities at death might consider a testamentary unitrust funded with an IRA as a potential solution. With this option, the IRA owner transfers his or her IRA to a unitrust at death. Since the unitrust is tax exempt, no income tax is paid when the IRA is distributed to the trust. The full IRA value is invested and produces new income to family for one life, two lives or a term of up to 20 years. After all payments are made, the remainder is transferred to designated charities.
To ensure that the transfer of an IRA is effective at death, the IRA owner will need to complete an IRA beneficiary designation form naming the trustee of the unitrust as beneficiary of the IRA. The IRA owner should work with an advisor to create the necessary documents in accordance with state law. In most cases, IRAs represent 100% untaxed ordinary income and the entire IRA distribution will be allocated to the tier-one ordinary income layer of the unitrust for four-tier accounting purposes. Thus, distributions to the IRA owner's children will be ordinary income. However, since the unitrust is tax exempt, the full value of the IRA will be available to earn new income for the children.
Bequest of IRA to Charity
Barbara Jones is working with her advisor to put together her estate plan. She wants to use her IRA to leave a legacy gift to her favorite charity after she passes away but also wants to ensure that she provides something for her daughter, Danielle.
Barbara's attorney assists her in creating an unfunded unitrust for her life plus a term of 20 years. Under state law, the unfunded trust is valid but will not be active until Barbara passes away. Barbara fills out a beneficiary designation form for her IRA naming the trustee of the unitrust as beneficiary (e.g., "To Jane Doe as trustee of the Barbara Jones Charitable Remainder Unitrust dated July 4, 2018"). The trust will receive the IRA after Barbara passes away, enabling the trust to make payments to Danielle for a period of 20 years. At the end of that time, the balance of the trust assets will be distributed to the charity.
Since charities are exempt from income tax, they are able to receive IRA assets without having to pay income tax on the value received. In contrast, as discussed above, if a child inherits an IRA, the child will pay ordinary income tax on the entire distribution amount received. If donors with large IRAs desire to transfer an inheritance to children and leave a bequest to charity, a tax-effective method is to transfer part (or all) of an IRA to charity and leave non-IRD assets, such as cash, securities and real estate, to children.
If an IRA owner has a taxable estate, the IRA could be subjected to both estate tax and income tax. For example, the individual could pay estate tax on the IRA and the beneficiaries could be subject to income tax on the IRA proceeds. By designating a charitable organization as beneficiary of an IRA, the owner's estate will receive a charitable estate tax deduction to help offset estate tax and the children will avoid paying income tax on the IRA.
Loan of IRA to Charity
Tina, a surviving spouse, has an IRA currently valued at $2 million. Because her estate is valued at $18 million, which is over the $11.2 million exemption amount, she anticipates that her estate will owe taxes when she passes away. She wants to provide for her children and her favorite charity in her estate plan. She sets up a meeting with her advisor, Dave, to talk about her options.
Dave suggests that Tina designate her favorite charity as beneficiary of her IRA and provide for the children by transferring them assets that will not be subject to income tax, such as her real estate holdings, stock portfolio and liquid assets. He explains that, by doing so, her estate will receive an estate tax deduction and the charity will be able to use the entire value of the IRA because it will not have to pay tax on the amount received. The children will receive the balance of her estate and can avoid the income tax that would have otherwise been due if they inherited the IRA. Tina moves forward with this cost-effective plan and is pleased that she is able to provide for her children and leave a legacy gift to her favorite charity.
For those who would like to use their IRA dollars to make a large charitable impact, there is another creative strategy that enables an IRA owner to make a large significant gift to charity during life without taking a taxable distribution. This strategy was described in PLR 200741016 and involves loaning funds from a self-directed IRA to a charitable organization with a fair annual rate of return or interest rate with payment to be due upon the death of the owner. The charity will use part of the loan proceeds to secure a life insurance policy on the life of the IRA owner. Then, upon the death of the IRA owner, the charity will use the death benefit to pay the outstanding loan amount. This option exists for IRA owners who have self-directed IRAs and can therefore invest in alternative assets outside of the approved investments that are available to traditional IRA owners. Ultimately, because the loan is an investment of the IRA, rather than a distribution, the transfer of funds is not taxable to the IRA owner. With this plan, an IRA owner can make a transfer above and beyond the $100,000 IRA charitable rollover limit and avoid paying taxes on the distribution or including the distribution as income for tax purposes.
John graduated many years ago from State University. He wants to give back to the University by making a major gift but lacks substantial liquid assets to do so. His IRA is valued at $5 million. John considers taking a $2 million distribution from his self-directed IRA and then making a gift to the University, but he does not want the large distribution to be included in his income for tax purposes. He approaches his advisor, Tom, for a charitable solution.
Tom suggests that John direct his IRA to issue a $2 million, 20-year interest-only loan to the University. Because the loan must pay a fair rate of return, the rate on the loan will be based on the applicable federal rate for loans, as published by the IRS. The loan will be payable upon the earlier of the term or John's death. John will still have to take RMDs from his IRA. He may choose to gift up to $100,000 of his RMD to the University as a qualified charitable distribution each year.
The University will be required to make annual interest payments on the loan. As such, the University will set aside $600,000 of the funds received in order to make interest payments on the loan. The University will then use $1 million of the loan for future premiums on a life insurance policy that it takes out on John's life. The remaining $400,000 will be used by the University for its current needs. When John passes away, the University will receive the proceeds of the insurance policy and repay the note to the IRA.
In PLR 200741016, the IRA owner requested two rulings based on the strategy described above. First, he requested a ruling that the loan from the IRA to the charity was not a prohibited transaction. Section 408(e)(2)(A) indicates that an IRA owner may not participate in a prohibited transaction, such as a Sec. 4975(c)(1)(B) loan of money to a disqualified person. In this case, the IRS determined that the charity was not a disqualified person in relation to the IRA owner because the IRA owner was not a board member or employee of the charity, nor did the IRA owner have control or a financial interest in the charity. As such, the IRS concluded that this arrangement is not considered a prohibited transaction that would cause termination of the IRA.
The taxpayer also requested a ruling that the strategy described above was not a prohibited investment in insurance by the IRA. Under Sec. 408(a)(3), an IRA is prohibited from investing in life insurance. Here, the IRS found that because the charity, not the IRA, is the owner of the life insurance policy with full rights of ownership and is the policy beneficiary, the IRA does not own a prohibited life insurance investment. Therefore, this arrangement was not a prohibited investment under Sec. 408(a)(3). As such, the IRS found that the loan from the IRA and the insurance strategy were permissible. While a PLR is not a precedent and applies only to that taxpayer, the ruling is useful in indicating how the IRS may rule based on a set of facts.
Loan of IRA Coupled with Bequest
There is an additional charitable IRA strategy that involves a loan from an IRA to a charitable organization (as described above) but does not include a life insurance policy. With this plan, the owner's self-directed IRA loans assets to a charitable organization and designates the charity as beneficiary of the IRA upon the death of the owner. The IRA owner makes IRA charitable rollover gifts to the charity during life to enable the organization to fund the interest payments on the loan. When the IRA owner dies, the charitable beneficiary will be able to satisfy the debt using the assets it receives from the IRA. This is a great option for a charitably inclined individual whose favorite charity is in need of capital for a current campaign or project.
Jane wants to give a substantial sum to her favorite charity's capital campaign so that it can begin construction on a new building. She is considering making a $1 million gift, but she lacks liquid assets to do so. She has a self-directed IRA, but does not want to take a large taxable distribution this year. Her advisor suggests that she direct her IRA to issue a $1 million loan with a fair rate of return to the charity.
Upon receipt of the $1 million, the charity is able to immediately put the funds toward the construction of its new building. The donor can make additional gifts each year in the form of IRA charitable rollovers to help the charity pay the annual interest payments on the loan. Jane also designates the charity as beneficiary of her IRA so that, upon her death, the charity can satisfy any unpaid interest and principal on the loan.
How an IRA will be distributed will ultimately depend on the goals and objectives of the IRA owner. With the total amount of IRA assets growing every day, advisors can expect to encounter an increase in the number of requests for guidance and advice from IRA owners. Various planning options exist, including plans that leverage tax-savings with charitable giving. For those clients who are philanthropically minded, transferring IRA assets to charitable organizations provides a tax-efficient solution. By understanding the basic rules surrounding IRAs, the distribution options available during life and at death and the tax implications for these options, advisors can provide clients with solutions that will meet their clients' personal and financial objectives.