By: Jay Duggan
Leaving a gift to charity through your IRA assets is one of the most tax-smart ways you can give.
Why? Because if you leave these assets to your children, they will receive it as taxable income, reducing the amount they receive by as much as 30-40% through taxes owed to the IRS, and most beneficiaries must withdraw this taxable money within 10 years.
Here is an explanation of the tax law changes concerning inherited non-spousal IRAs and a charitable gifting strategy from your retirement account:
- For many who inherit IRAs or 401(k)s starting in 2020, the SECURE Act eliminated the ability
to “stretch” your taxable distributions and related tax payments over your life expectancy. - If you’ve inherited an IRA on or after January 1, 2020, and you cannot stretch your
distributions, you may need to withdraw the balance of the account no later than the 10th
anniversary following the calendar year of the IRA owner’s death. - There are 3 possible strategies to consider based on your situation: (1) withdraw the assets
as evenly as possible over the 10 years, (2) wait until the end the of the 10-year period and
then withdraw everything, and (3) make irregular withdrawals over the 10-year period.
In December 2019, Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. The act includes many reforms that could make saving for retirement easier and more accessible for many Americans. But there is one potential downside: If you inherit an IRA or 401(k) from someone other than your spouse, the SECURE Act could impact your retirement savings plans or strategies to transfer wealth to future generations.
Prior to the act, if you inherited an IRA or 401(k), you could generally “stretch” your taxable distributions and tax payments out over your life expectancy. Many people have used “stretch” IRAs and 401(k)s as a reliable lifetime income source. Now, for IRAs inherited from original owners that passed away on or after January 1, 2020, the new law requires most beneficiaries to withdraw assets from an inherited IRA or 401(k) plan within 10 years following the death of the account holder. The IRS’ proposed regulations on required minimum distributions (RMDs) published on February 24, 2022, would require distributions to be made on an “at least as rapidly” basis during the 10-year period and then a complete distribution in year 10, provided the deceased employee or IRA owner had already begun taking RMDs.
The Exceptions
Generally speaking, people who inherit an IRA or 401 (k) from their spouse can stretch out their required minimum distributions (RMDs) over the course of their lifetime. You may also be able to stretch distributions if you fall into one of 3 other common types of eligible designated beneficiaries:
- A minor child (not grandchild) of original owner (2)
- Someone less than 10 years younger than the original owner
- Someone disabled or chronically ill (as defined under the applicable sections of the Internal Revenue Code
(Fidelity article)
Now if you (as a donor) are charitably inclined and desire to leave or make a legacy gift to impact a non-profit that is meaningful to you, leaving a percentage of your IRA to charity is a smart way to give because of the tax law changes mentioned above! A non-profit (unlike a child or grandchild) can receive their percentage of your IRA TAX-FREE. For beneficiaries, other than non-profits, each distribution over the 10-year time period will be counted as taxable income to them, which in many cases could add up to 30-40% in taxes owed to the IRS! This is why leaving gifts to charity from retirement assets can be one of the most tax-wise ways to give. Naming a charity as a contingent beneficiary is easy, all you have to do is contact your financial advisor to make the change and sign a beneficiary designation form. It does not require hiring an attorney to update your will/trust! For example, if you have two adult children named as contingent beneficiaries to inherit your IRA worth 1,000,000.00. On your passing, two IRA’s worth 500,000.00 each would be established in their names, and each would be required to distribute the full amount within ten years. If they choose to distribute 50,000 each year, it will be taxed as earned income to them, likely pushing them into a higher tax bracket.
Now let’s say you are interested in naming your non-profit as an additional contingent beneficiary to your IRA, it could work like this on your passing.
1,000,000.00 IRA
Non-Profit: 20% = 200,000.00 (Tax-free gift)
Child 1: 40% = 400,000.00 (Taxable Ten-year distribution rule)
Child 2: 40% = 400,000.00 (Taxable Ten-year distribution rule)
Remember that pre-tax assets like retirement accounts do not step up in value when inherited. Step-up in basis refers to the adjustment in the cost basis of an inherited asset to its fair market value on the date of the decedent’s death. Cost basis is what determines the taxes owed, if any, when the asset is sold. Cost basis starts with the price paid for an asset, plus any additional costs added over time to improve or maintain the original asset. Step-up in basis, or stepped-up basis, is what happens when the price of an inherited asset on the date of the decedent’s death is above its original purchase price. The tax code allows for the raising of the cost basis to the higher price, minimizing the capital gains taxes owed if the asset is sold later. The step-up in basis provision applies to financial assets like stocks, bonds, and mutual funds as well as real estate and other tangible property. (Investopedia)
For this reason, all donors should seriously consider exploring with their financial advisors gifting assets to charity from their retirement accounts on their passing and determine if this strategy fits into their overall estate planning strategy.
