Who Gets What? A Guide to Tax-Savvy Charitable Contributions
by James Lange, CPA/Attorney
Reprinted with permission from Forbes.com. where Jim is a regular contributor.
Let’s address the decisions you make when crafting your estate plan and figuring out who gets what. What is the smartest solution for donations or inheritances that you leave to a charity after you and your spouse pass? The most fundamental idea to address is: what are the tax implications to each recipient if they inherit your money? By being very selective about who receives which type of money—whether Traditional or Roth IRAs, after-tax brokerage accounts, life insurance, etc.—you can dramatically cut the share that goes to the IRS and increase the amount going to your family.
In most cases, Traditional IRAs are going to be fully taxable to your heirs. After the SECURE Act killed the stretch IRA, income taxes will be due on your IRA within ten years after your death. Inherited Roth IRAs have the advantage of being able to continue to grow for ten years after your death and then can be withdrawn tax-free. After-tax dollars and life insurance are generally not subject to income taxes. All these different types of inheritances have different tax implications for your beneficiary—unless your beneficiary is a tax-exempt charity.
A charity recognized by the IRS as being tax-exempt does not care what form of inheritance they receive. They never have to pay taxes on the money. So, a charity will look at bequests of Traditional IRAs, Roth IRAs, after-tax dollars, or life insurance in the same light. In sharp contrast, your heirs will face substantially different tax implications depending on the type of asset they receive after your death. Please note that we are only addressing income taxes, not estate or transfer taxes.
Imagine this scenario. You want to leave $100,000 to charity after you and your spouse die. You have both Traditional IRAs and after-tax dollars. Who Gets What? In most of the estate documents we review, we see instructions directing that the charitable bequest come from after-tax funds—usually found in the will or a revocable trust. The problem is that your will (or revocable trust) does not control the disposition of your IRAs or retirement plans. By naming that charity as a beneficiary in your will or trust, you will likely be donating after-tax money to charity. The charity gets $100,000 so the “cost” of the bequest to your heirs is $100,000. Restated, the amount that your children inherit is reduced by $100,000 because you made that bequest to charity.
But what if you decide to leave $100,000 to charity through your Traditional IRA or retirement plan beneficiary designation? It makes no difference to the charity because they get $100,000 tax-free. If your heirs receive $100,000 from your IRA, they will have to pay taxes on the money. Assuming your heirs are in the 24% tax bracket, that would be $24,000—leaving them with $76,000 after the government takes their share. And the tax bite is even worse if your heirs are in a higher tax-bracket or live in a state that taxes Inherited IRAs. So, if you leave your Traditional IRA money to a charity that doesn’t pay taxes, you are in effect leaving your beneficiaries an extra $24,000! This is a simple tweak to your estate plan that can be very beneficial to your heirs.
Consider the purchasing power, after taxes, available to your beneficiary if you have $100,000 in a Traditional IRA and $100,000 of after-tax dollars, and we switch who gets what.
- Leave $100,000 to charity through your will or revocable trust and $100,000 to your heirs as the beneficiary of your Traditional IRA.
- Impact on charity: $100,000 and pay no tax.
- Impact on heirs: $100,000 IRA – 24% taxes = $76,000.
- Leave $100,000 to charity through your IRA beneficiary designations and $100,000 to your heirs in your will or revocable trust.
- Impact on charity: $100,000 and pay no tax.
- Impact on heirs: $100,000 and pay no federal tax.
This simple switch of who gets what saved this family $24,000!
Let’s imagine another scenario. Suppose your child is well off and, as a parent, you are totally comfortable with reducing his or her inheritance by $100,000. Does that mean you can leave even more money to charity? Yes!
You could leave $131,579 to charity through your IRA or retirement plan beneficiary designation. The same tax implications apply. A $131,579 IRA bequest will only “cost” your child $100,000 ($131,579 times 24% = $31,579). If you left that $131,579 IRA to your children instead of charity, your children would have to pay $31,579 in taxes leaving them $100,000.
By switching who gets what, you accomplish one of two things:
- You save $24,000 in federal taxes for your child, or
- If you increase your bequest to the charity to $131,579, you still only remove $100,000 from your child’s total inheritance, and you increase the charitable gift by $31,579.
Who loses with this strategy? The IRS! You are giving the IRS a smaller piece of the pie. I think that all of us can safely agree that we want more money to go to our kids, more money to go to our favorite charity, and less money to go to the IRS.
Investment advisory services provided by Lange Financial Group, LLC. Content provided herein is for informational purposes only and should not be used or construed as investment advice. All information or ideas provided should be discussed in detail with an advisor, accountant, or legal counsel prior to implementation. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.