Charitable Gifts of IRA / IRD Assets The Good, the Bad and the Ugly. Susan C Dunlop Luther Seminar - Gary G Hargroves Thompson & Associates

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1 1 IRD Definition: Charitable Gifts of IRA / IRD Assets The Good, the Bad and the Ugly Susan C Dunlop Luther Seminar - Gary G Hargroves Thompson & Associates Minnesota Planned Giving Conference November 5, 2014 Income in Respect of a Decedent (IRD) is taxable income to which the deceased person was entitled, but did not receive before their death. An IRA is one of the most common examples of IRD assets but it also includes 401k s, 403b s, other qualified pension assets and other types of assets. Charitable Gifts of IRA/IRD via a Beneficiary Statement For the vast majority of people today, a gift of IRA/IRD assets is the most common, easiest and tax-advantaged way to make a planned gift. Switching a planned gift from a will or trust to a IRA/IRD assets beneficiary statement can dramatically increase the amount of an estate going to heirs while still making the desired charitable gift. A planned gift of IRD assets can be made by simply changing the beneficiary statement to designate a charity or charities. All custodians provide a beneficiary form that includes a place for primary, contingent or secondary beneficiaries. While these usually only have a line or two for the beneficiary, most custodians allow for additional pages to be attached which can describe in detail the beneficiary designation. There is no cost for changing the beneficiary designation and in most cases it can be either done on-line or the form can be printed, completed and mailed. This can be done by the account holder. The services of an attorney or other professional advisor is not needed unless the person prefers to have this counsel. The tax advantages of making charitable gifts of IRD assets are significant. IRD assets left to heirs are subject to income taxes, and Federal and Minnesota estate taxes. When given to charity there are no income or estate taxes and there is an unlimited charitable deduction. For persons whose estates are subject to maximum taxation, the combined taxes on IRD assets can be nearly 80%, leaving the heirs only about 20% of the original value. By contrast, appreciated assets such as stocks and real estate get a step-up in basis as of the date of death of the owner. In addition, these are after tax dollars so

2 2 there are no income or capital gains taxes when given to heirs. It clearly makes a great deal of tax sense to give IRD assets to charity and other assets to heirs. IRD assets directed by a beneficiary statement go directly to the charity and are not a part of probate. A charity receives the intended gift sooner and, unlike a gift by will, it is not subject to public review. It is possible to significantly increase the odds of a charitable gift being received. Since most people think of charitable giving as a % of their whole estate, along with the charitable beneficiary designation, it is important to encourage people to include in their wills / trusts language that directs that a % of their estate to their charitable interests. The following is sample language for you, your donor s and their attorney s consideration. I give % (or an amount) of my net estate, after payment of expenses, to the charities listed in Appendix A. To the extent this amount is not realized by other gifts from my estate, I instruct that this amount be satisfied in cash or in kind and the (personal representative and/or trustee) can allocate different assets to the different residuary beneficiaries in satisfaction of their percentage interest in the residue of the (estate or trust.) (As of October 2014, either this language or something very close to it must be used.) This is beneficial because wills and trusts are more substantial documents than are beneficiary statements and should be prepared by an attorney. As a results, they tend to be around longer and are not as easily or quickly changed. Second, if they are changed, usually, the donor and attorney will start with the current will / trust and make the needed changes. By doing that, they will see the intended charitable gifts and carefully consider if those need to be included in any new beneficiary statement, will or trust. Third, a will or trust is in place indicating the intended charitable gifts, normally the family and/or advisors will review these before processing the estate of the deceased and beginning the process of rolling over the IRD asset from one spouse to another. In that process they will hopefully recognize the tax advantages for the donor and their heirs by continuing to make charitable gifts of IRD assets and include charity as a primary beneficiary in the new rolled over IRD asset to the surviving spouse. Fourth, if this is not observed in the process of rolling over the IRD asset and the heirs are made the primary beneficiary, the charitable gift will be made from estate assets. The Bad: The value of the charitable gift, as a percent of one s estate, using the IRD assets beneficiary statement, is difficult to track across time.

3 3 People tend to think of their planned gift as a % of their estate. Since a person never knows for certain what the value their estate or their IRD assets will be at death, it is hard to calculate on an ongoing basis what percent of their estate their current beneficiary gift represents. While it is fairly easy to calculate this at the time the gift is being made, i.e. what % of IRD assets equals the % of one s total estate, the asset numbers and especially the IRD values can change quickly. One relatively easy solution to this is to set up a separate IRD account funded with the amount that one desires to go to charity. Unfortunately, both donors and account custodians are reluctant to do this. As a result of this reluctance, this rarely happens. An ideal circumstance would be, that the donor sets up a separate IRD Charitable Account and that a development officer has a lifelong, active and close working relationship with the donor and help them manage their intended gift across time. This also rarely happens. Many donors are reluctant to give development officers that much information about their estate. And, development officers rarely stay at an organization for the 10 to 20 years needed to track and adjust such gifts during the donor s life time. When a development officer leaves an organization, a new development officer often does not work with all the same donors the former development officer stewarded. The donor is viewed as simply a planned gift donor and the new development officer is assigned to look for new planned gift prospects. The result is, a great many planned gifts are lost. The easiest planned gift to raise is simply to keep and enhance the planned gifts you already have. In addition, there may also be organizational leadership changes. It is not uncommon for a new leader to have a different point of view about what it means to work with and steward planned gift donors for the rest of their lives. Even donors themselves, in many cases, do not carefully track the results of their beneficiary statements for their heirs and charitable giving on a regular basis. The Ugly: The frustrating part of charitable gifts of IRD assets is that the odds of the charity actually receiving the gifts is low, especially if the charity starts as a contingent beneficiary. There are a great many things that can go wrong between the time the gift is planned and the time when it should be received. First, since IRD assets are designed for retirement income, there is a good possibility that most or all of the assets will be used for the donor s retirement living. Second, since most of these asset are invested in various types of equities, which are subject to the market forces of gains and losses and sometimes the losses can be substantial and devastating. Third, is the number of years and changes that can happen to the donor between the time the gift is established and the time of death. Most often charitable gifts of IRD

4 4 assets are made when donors are in their 70 s and they are likely to live for another 15 to 20 years. Fourth, if the donors are a married couple, the charitable designation is usually a contingent beneficiary and spouse is the primary beneficiary. Most often, the husband has the primary IRD assets and the wife is the primary beneficiary. In this scenario, if the couple lives to their late 80 s or 90 s, and the husband dies first, in the process of rolling the IRD assets from the husband to the wife, the wife may not be as mentally competent as she was in her 70 s. She may have forgotten about the charitable commitment that was made 20 years earlier. Also, her family and/or other advisors may suggest, in the process of rolling over the asset to her, that she simply make her heirs the beneficiary of her IRD after her life. If that happens, the earlier intended charitable gift is lost. While the above points addresses a couple, the same principles apply for an individual who wants to first direct IRD assets to heirs and then to charity. However, often a single individual will include their charitable interests as one of the primary beneficiaries and thus the gift will be realized at the death of the owner. Fifth, unless a development officer or the charity has maintained a close personal, working relationship and quality personal stewardship during those intervening years, the interest in or relationship to the charity may have changed. Sixth, to further add to the risk of losing the IRD gift, a number of people move to other locations and develop other charitable interests and advisors. The IRA Rollover The IRA Charitable Rollover legislation, established under the 2006 Pension Protection Act, allows individuals who have reached age 70½ to donate up to $100,000 to charitable organizations directly from their IRA, without treating the distribution as taxable income. In order to qualify, contributions must go directly to a public charity and be made from traditional IRAs or Roth IRAs. Donors may receive no goods or services in return for their contributions, and must obtain written documentation of their contribution from each recipient charity. Since the legislation was first enacted, Americans have given hundreds of millions of dollars to nonprofits that benefit people every day. The tax benefits of the IRA Charitable Rollover are especially beneficial to older Americans who may have paid off their home mortgage and no longer file itemized tax returns. The mandatory distribution from their IRA would otherwise trigger a tax burden, even if they donate the money to charity. The IRA rollover provision removes these negative tax consequences and encourages Americans to give back to their communities during their lifetime.

5 5 To report an IRA charitable gift on one s tax return, since the IRA administrator often does not make any distinction between charitable and non-charitable IRA distributions, the burden falls on the IRA owner to make the adjustments on his or her personal return. From a policy perceptive this is a good practice since the IRA owner is in the best position to know whether a charitable distribution in fact qualifies for the charitable IRA exclusion or not. The IRA owner should report all of the IRA distributions on the front page on the income tax return (Form total distributions on Line 15A) but should then report only the taxable distributions on line 15B. Thus, the charitable IRA exclusion will be reported similarly to a traditional rollover, where a person may have received a taxable distribution from an IRA but is able to avoid taxation by rolling over the amount within 60 days to another IRA. These charitable IRA gifts will not be disclosed in any way on Schedule A, where a person claims an itemized income tax deduction for conventional charitable gifts. If the donor is going to make a charitable gift anyway, either with or without the legislation being in place, it is perfectly appropriate to make a direct gift to charity from their IRA and then complete their income tax return appropriately as described above. The Bad: Only available for traditional and Roth IRA s; does not apply to gifts from other IRD assets. The donor must be 70 ½. Younger donors would like to give if they were allowed. It takes extra work. It is simplier and easier to write a check or use a credit card. It is somewhat inconvenient to make an IRA Rollover gift. Each IRA custodian (Vanguard, Fidelity, etc.) sets up requirements such as the minimum gift. The Ugly: Government inaction is the most discouraging part of making an IRA Rollover Gift. Most donors advisors do not encourage or advise them to make a rollover gift unless the government has passed legislation approving the rollover. These gifts are part of what is called tax extenders. These are tax provisions that the government has not made permanent and in the case of the IRA Rollover have been passed for two year terms. Unfortunately, the government tends to either pass this legislation late in the year or on occasion even in the following year for the prior year. The IRA Charitable Rollover is not permanent even though The Independent Sector has been urging Congress to provide greater certainty for taxpayers and the charities they support. The uncertainty caused by the need for extensions, as well as the fact that the provision has been allowed to lapse, makes it difficult for people to effectively manage their finances and plan their estates. This uncertainty diminishes the incentive effect of the IRA Charitable Rollover, which reduces charitable giving and increases the tax burden on older Americans.

6 6 On July 17, 2014 the House of Representatives passed by the America Gives More Act (H.R. 4719), which included making the IRA charitable rollover permanent. The Senate has not passed this legislation as of October 6, Government inaction leads to considerable confusion and complexity and is a significant deterrent to donors in making IRA Rollover gifts throughout the year. The independent minded, do-it-yourselfer, will be frustrated until they learn the IRA Rollover process. Until then, most donors, need to call their custodian and request their assistance. Custodians do not encourage the account owners to make IRA Rollover gifts but do provide a great deal of information about how to make gifts to the custodian s charitable fund. Custodians are required to have a process in place for making IRA Rollover gift but they make it very cumbersome to do so. For example, this is how to make a Charitable IRA Rollover gift from a Vanguard fund: Forms > Buy or Sell > View All > Distribution from a Vanguard IRA (toward bottom of list) > IRA Distribution Kit > Option C > Make Check Payable to Someone Else. Other custodian are no better and searching doesn t work. The IRA/IRD Funded Charitable Remainder Unitrust (CRT) Funding a charitable remainder trust (CRT) or charitable gift annuity (CGA) with IRA/IRD assets can solve many family, tax, and estate planning issues. It is tax-efficient because income taxes are avoided at the time of transfer to the CRT or CGA. In addition, estate taxes are reduced by the value of the CRT/CGA charitable deduction. This is sometimes referred to as a give it twice gift; from which both charity and the heirs benefit. Plus, significant lifetime income to a surviving spouse and/or other heirs results from naming a CRT or CGA as beneficiary of IRA/ IRD assets. The income received from reinvestment of the entire amount of the retirement benefit without the reduction of Federal and State Income Taxes, may be equal to or be more than if the IRA/IRD assets were inherited outright by heirs and then invested, because income taxation would substantially reduce the amount inherited. If a spouse is the first beneficiary; children and/or grandchildren may receive income after the surviving spouse s life, for their life or 20 years, whichever is longer. Using a CRT for multiple adult beneficiaries with varying ages is easier than using a non-charitable trust. A non-charitable trust needs to calculate the MRD (minimum required distribution) for multiple persons and would either have to use a trust for each person, or use the oldest beneficiary s life expectancy to measure the MRD.

7 7 The CRT must meet IRS requirements including an annual payout to the heir(s) of at least 5% and not more than 50% and a remainder to charity of at least 10% of the value of the trust. Depending upon the payout rate and management of the CRT, its value may increase as the income beneficiary ages. However, an IRA account s value is designed to expire as ever larger annual Required Minimum Distributions are made. (RMD is based upon the IRS life expectancy tables, and increases as a person ages.) A CRT, designed to provide steady lifetime income, may be helpful for benefitting an elderly non-spouse beneficiary because of avoiding income taxation at the transfer of the IRA/IRD assets to the CRT and avoiding the Required Minimum Distribution (RMD). Once the CRT is funded, no one may change the charitable remainder beneficiary designation -- unless the trust includes a provision allowing for a change of the charitable beneficiary. Thus, the donor s designated charity will benefit; not the charity of the surviving spouse s new spouse or step-children. The CRT also protects assets from heirs creditors. And, the surviving spouse or other heirs need not serve as trustee and take responsibility for managing the IRA/IRD investment portfolio. Plus the costs associated with financial management of the CRT by the charity may be lower than costs for managing the IRA/IRD assets. The Bad: The surviving spouse or other heirs may need the assets outright for their health care and maintenance. The income beneficiaries only receive the annual distributions and do not have access to the principal. Heirs pay ordinary income taxes on their CRT income payments based on what is called the four tier system established by the IRS for CRTs. Since The CRT is funded with Income in Respect of the Decedent (IRD), it is all Tier 1 income. All income from one tier must be reported and exhausted before income from the next tier down is reported. Within each of the first three tiers, a hierarchy of classes of income is created based on the highest federal income tax rate that can be imposed on each class. (The CRT s losses and deductions are apportioned among these tiers and classes.) The four tiers are: Tier 1: Ordinary income - interest income, dividend income, and rent income from real estate. Tier 2: Capital Gains income income for the sale of appreciated assets such as securities or real estate. Tier 3: Tax Exempt Income such as municipal tax-exempt bonds.

8 8 Tier 4: Return of Principal income taken from the principal. The Ugly: If the IRA/IRD beneficiary designation language on the beneficiary designation form, and/or in the will or trust, is incorrect, the CRT will not be funded and the assets will be subjected to income taxation. To prevent this, the correct beneficiary designation language needs to used; such as: The Robert and Marilyn Burman Charitable Remainder Unitrust at Luther Seminary Foundation, St. Paul, MN. The account owner s Required Minimum Distributions have depleted their IRA/IRD assets or the remainder value at their death is too small to fund a CRT. Most charities required minimum is $100,000. The CRT is irrevocable once funded, and the remaining estate is diminished by estate taxes. The charitable remainder does not meet the IRS 10% remainder rule. IRA/IRD Funded Special Needs Trust / CRT The Special Needs Trust (SNT) keeps a loved one from being disqualified from meanstested government benefits. The IRS allows IRA/IRD account holders to designate a CRT as beneficiary of these assets with a SNT as the income beneficiary. And because the CRT receiving the full distribution of the IRA/IRD is tax-exempt, there is no income taxation on the assets. The CRT then pays an irrevocable income stream to the Special Needs Trust. A SNT funded by income from a CRT enables the account holder to accomplish their estate planning goals at the same time as they fulfill their charitable goals. They can both take care of a loved one with serious health challenges and benefit their favorite charities. The CRT provides the account owner with a charitable income tax deduction and a reduced income or estate tax bill. The SNT can also name individuals or a charity as the remainder beneficiary. The CRT s income to the SNT may be for the SNT s beneficiary s lifetime. The Bad: The cost associated with setting up two trusts; both the CRT and the Special Needs Trust. In order to keep the loved one from being disqualified from means-tested government benefits; a Special Needs Trust must be set up as an accumulation trust rather than a

9 9 conduit trust (an accumulation trust will allow the IRA distributions to accumulate in the trust rather than being paid out directly to the beneficiary so as not to lose valuable means-tested government benefits). The Ugly: The CRT income may not be adequate income for the Special Needs Trust. Outright Gift from IRA to Charity This outright gift to benefit a charity s mission is very helpful. If the donor itemizes their taxes, they may deduct the full amount of the outright gift up to 50% of their Adjusted Gross Income. Tax wise, the gift is a wash, but it may lower income and estate taxes. The Bad: The outright IRA gift results in paying more taxes for the non-itemizer. And because it may trigger additional taxation on Social Security Income. The Ugly: The donor may be jeopardizing their finances to make this gift if given in response to pressure from charity. And if they are younger than 59 ½ years of age, they will pay an IRS penalty. Qualified Terminal Interest Property Trust with Charity as a Remainder Beneficiary Qualified terminable interest property (QTIP) is property in a person s estate that, even though subject to certain restrictions, can still qualify for the estate tax marital deduction. When property is left (or given) to a surviving spouse, there is an "unlimited marital deduction," allowing the transfer of any amount of property, during life or at death, without triggering either the federal estate tax or the federal gift tax. The IRS allows QTIP Trusts to be used for IRA/IRD assets with charity as a remainder beneficiary. Using a QTIP Trust with charity as the beneficiary generates a 100% estate tax charitable deduction at the death of the surviving spouse. The surviving spouse has the right to income for as long as they live; either income payable annually or at more frequent intervals. The QTIP Trust provides lifetime financial security to the surviving spouse, but retains control over the remainder beneficiary. This is useful if a donor wishes to ensure that the Trust s remainder benefit goes to their favorite charity/ies. If the QTIP Trust is not

10 10 used for the asset transfer to the surviving spouse, the beneficiary designations can be changed. The QTIP Trust addresses the "remarriage fear." If property is left outright to a surviving spouse who later remarries, the property could wind up in the hands of the new spouse or their children. The Bad and the Ugly: It is irrevocable after the first spouse s death.