Charitable giving can become messy when it involves multiple beneficiaries and retirement and nonretirement assets.
Question: My client wants to leave his estate, which includes a substantial IRA and other assets, to a collection of individual and charitable beneficiaries in varying percentages. Some of the charities are big and some are small churches or 501(c)(3)s. It would make sense to fund the charities' shares with the retirement benefit asset (the IRA) because the charities will pay no income tax on the IRA proceeds, whereas if the individuals' shares are funded with IRA assets their net inheritance will be reduced by income taxes. Is there a way to accomplish this?
Answer: I agree with the wisdom of the simply-stated plan--fund the charities' shares with the IRA, and the human beneficiaries' shares with non-IRA assets, to the extent possible. It's not as easy to do this as it is to say it, though. Here's the obstacle course to navigate.
The Trouble with Naming Charities as IRA Beneficiaries
It seems like this approach should be the easiest. But some IRA providers don't like to get a long list of beneficiaries with different percentages as a beneficiary designation. Also, some clients find it cumbersome to re-file beneficiary designations with the IRA provider whenever they change their mind about which beneficiaries should receive what shares.
Here's another problem, one I hear about it more and more. Suppose your client's IRA beneficiary designation says, "I name My Local Church and My Favorite University as equal beneficiaries." The client dies and then the charities find out, but the IRA provider won't simply issue the charities a check upon presentation of proper identification and Form W-9. Rather, the IRA provider says, "We can't deal with you because you are not our customer. Before we can give you any of the IRA money, you must first open an inherited IRA account with us. Once you’ve opened that account, we will transfer your share of the decedent's IRA into your newly opened inherited IRA. Then you can do whatever you want with the money, including withdraw it the next day and close the account."
The problem is that opening an inherited IRA is not necessarily easy for a charity. For example, let's say that My Favorite University is governed by a board of 48 trustees; the IRA provider wants full information about each and every one of them--name, address, Social Security number, proof of citizenship, even information about each trustee's spouse, relatives, and business connections! ("Required by anti-money-laundering laws," says the IRA provider.) And it turns out that the entire staff of My Local Church is one elderly overworked clergyman who has no time for complex paperwork.
To avoid this difficulty, consider opening a donor-advised fund run by a major financial institution, community foundation, or umbrella charity. Name the DAF as beneficiary of the IRA, and provide the DAF with the list of charities that are to receive the IRA money after the client's death.
A large, experienced DAF named as IRA beneficiary can easily comply with the IRA provider's paperwork requirements, and then dole out the IRA money to the charities that the client had selected in advance. It's usually easier to change beneficiaries for a DAF than it is for an IRA, and experienced DAF sponsors are expert in the legal and paperwork requirements for getting the money out to the charities.
Passing IRAs to Charities Through Personal Trusts
Leaving the IRA benefits to charity through a DAF does not work for everyone. For example, the client may have a formula in mind based on the date of death value of all her assets. Suppose she wants the charities to receive 30% of her total estate, and the IRA exceeds that share. She should consider leaving all her assets including the IRA to the trust. The trust instrument states what percentage of the total trust each beneficiary is to receive and specifies that the IRA shall be used "first" to fund the charities' shares. Does that work?
This approach is a little trickier and requires great care at the drafting and administrative stages. The good news is that the IRS's own regulations contain an example blessing the "use-IRA-assets-to-fund-this-share-first" language. Accordingly, with that clause in the trust, the trustee should be able to:
>Transfer the IRA to the charities with no income tax impact on the trust, provided the trust instrument permits the trustee to satisfy bequests by transferring assets "in kind" and does not require that each beneficiary receive a pro rata share of each asset. The bad news is that transferring the IRA from the trust to the charities can involve a lot of paperwork (and the same obstacles discussed above under "Leave the IRA to charity").
>Withdraw cash from the IRA (thereby generating gross income to the trust) and then distribute that cash to the charities (to get a charitable income tax deduction). For this to work, normally a separate account is used so that the IRS can trace the actual path of the dollars distributed from the IRA then transferred to the charities. Also, the timing of the IRA distribution and payment out to the charities is critical. This approach may pose problems if the trust has municipal bond interest or other "classes" of income, as regulations may require pro rata allocation of the various classes of income among all the beneficiaries. Basically, the charitable income tax deduction rules for trusts are complex--and are zealously enforced by the IRS.
The bottom line: Leaving retirement benefits to charity is a wonderful way to benefit charities and minimize income taxes at the same time. However, there is no absolutely problem-free way to do it if the client is also trying to benefit human beneficiaries at the same time, and has both retirement-plan assets and other assets. The key to success is plan for distribution of these assets during the estate planning phase. That will make the administration phase relatively problem-free. Without careful planning, the IRS may collect an unintended share of the IRA!
Where to read more: For detailed discussion of the fiduciary income tax charitable deduction, see the author’s special report, Charitable Giving with Retirement Benefits ($49.95), downloadable at https://www.ataxplan.com/downloads/charitable‑giving‑with‑retirement‑benefits/.
Natalie Choate will be speaking in Indianapolis, IN (9/13/17); San Diego, CA (10/27/17); Philadelphia, PA (11/14/17); Plymouth, MI (12/7/17); and Orlando, FL (Jan. 25-26, 2018). See all of Natalie’s upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.