Charitable Planning Strategies for Qualified Plans and IRAs

The combination of estate and income taxes that apply to Qualified Plans and IRAs (hereafter referred to as “Plans”) can reduce the benefit to a non-spouse beneficiary by up to 70%.  Because the tax impact can so dramatically reduce the amount received by a non-spouse beneficiary, using the Plan assets for charitable giving can be a very cost efficient method to make desired charitable gifts.  If, during the Plan owner’s lifetime, distributions are used to replace the value of a charitable gift, the non-spouse beneficiary can also receive a benefit.  This strategy is particularly effective if the Plan owner does not require the Plan assets for funding his or her retirement needs.  Careful planning can avoid the double tax trap and enable the Plan assets to provide benefits for both family and charity.

The rules relating to Qualified Plans were primarily intended to provide an income tax deferral, but limited the time during which receipt of income could be postponed.  The primary reason for allowing deferral was to encourage savings for retirement.   Providing benefits to the Plan Owner’s beneficiaries was not a primary purpose of the rules.  Theses distribution rules have been simplified by the January 11, 2001 proposed regulations, but they still exist as to the required beginning date of distributions and the time limit of distributions.  The general rule is that distributions are required by begin by April 1st of the year following the year the owner attains age 70 ½ and continue annually over the distribution period.  The distribution rules also provide for a minimum required distribution (“MRD”).  This is determined on the required beginning date based on the table and the account balance as of December 31 of that year.  The table bases the distribution period on the life expectancy of the owner and of a designated beneficiary deemed to be ten years younger unless the designated beneficiary is a spouse who is more than ten years younger, in which case the actual joint life expectancy applies.

If the spouse is the beneficiary and the Plan owner dies first, the spouse can “roll over” the Plan and name a new designated beneficiary and start the clock again.  If the beneficiary is a non-spouse, upon the death of the Plan owner, the period of distribution becomes the life expectancy of the designated beneficiary.

There are strategies to extend the distribution period by naming children or grandchildren as designated beneficiaries.  This enables distributions to continue after the death of the owner for the life expectancy of the young beneficiaries.  For this strategy to be effective, however, the pro rated share of estate taxes due on the value of the Plan must be paid from non-Plan assets.  If the estate taxes are paid from the Plan assets, the spiral of income and estate taxation rears its ugly head.  Each dollar withdrawn from the Plan to pay estate tax incurs incomes tax.  The result is a combined income and estate tax of up to 70%.  This has a devastating effect on the amount passing to the beneficiary.  A plan valued at $2 million can be reduced to approximately $600,000.  The legacy you intended to leave is reduced dramatically by income and estate taxes.

Fortunately, there is an alternative that, if adopted, can provide substantial benefit to both family and charity.  The first part of the strategy involves naming a charity (or charities) as beneficiary of the Plan if the spouse does not survive or, if the spouse survives, he or she can roll over the Plan and name the charitable beneficiary.  By naming a charity, the estate receives a dollar-for-dollar charitable deduction and incurs no estate tax on the Plan assets comprising the charitable bequest.  Since the after-tax benefit to the non-spouse beneficiary would have been only approximately 30% of the value of the plan assets, naming a charity as the beneficiary has little impact on the non-spouse beneficiary, yet provides a very substantial gift to charity.

The second part of the strategy involves using the minimum required distribution (or a greater distribution if needed) during the owner’s life and the life of his or her spouse to pay the premium on a second-to-die life insurance policy owned by an Irrevocable Trust.  This is particularly efficient if the distributions are not required to provide retirement income.  If the income is required for retirement needs, an increased distribution may be taken to pay for the insurance.  However, careful planning is needed to chart the longevity of the Plan assets based on the distributions required.  The amount of the insurance could be the amount the non-spouse beneficiary would have received, but is often greater because the distribution from the Plan can support the required premium.

Upon the death of the second to die, the Irrevocable Trust will receive the death benefit free of income or estate taxes.  Additional planning can enable the Trust to 1) continue for the life of the non-spouse beneficiary, 2) have the use of the Trust assets and, 3) upon death, have the then Trust principal be paid estate tax-free to the next lower generation.  This can result in a substantial increase in the amount received by the next generation.

In summary, Qualified Plans and IRAs are subject to both estate and income taxes, thereby having a devastating effect on the amount the non-spouse beneficiary receives.  The strategy of having a charitable beneficiary coordinating withdrawals from the Plan with the purchase of insurance owned by an Irrevocable Trust, significant charitable and family benefits can be achieved.

In the last issue of the Peconic Land Trust’s Newsletter, I discussed a similar wealth replacement plan involving Charitable Remainder Trusts.  This method of charitable giving and wealth replacements with the assets being ultimately given to charity has application in many areas.  If there is a downside, it is for the IRS.  The upside is for you, your charities and your family.  It is a fine legacy to leave.