Depending on your situation, this may be excellent advice from your representative. You work hard to earn and save your money. Why give “more than your fair share” to the government in taxes? Distributions from your IRAs after your death may be the most heavily taxed assets you own. Review the following to see if it’s right for you to name a charity as the ultimate beneficiary for some or all of your IRAs.
TAXES PAID BY NONCHARITABLE BENEFICIARIES
After your death, your beneficiaries (spouse, kids, other family members, friends) may face up to seven different types of taxes on your IRA distributions:
Federal income tax
State income tax
Local income tax
Federal estate tax
State estate tax
Federal generation-skipping transfer tax
State generation-skipping transfer tax.
If all of these taxes were to apply to your situation, the combined tax hit could be in excess 80 percent. This could leave less than 20 percent of the IRA distributions for your loved ones. The tax impact may be lessened by naming your surviving spouse as the primary beneficiary. Here are some of the details on these taxes and some strategies to consider.
INCOME TAX FOR NONCHARITABLE BENEFICIARIES
Distributions from traditional IRAs are subject to income tax at the beneficiary’s personal income tax rate as the distributions are received. This can be as high as 35 percent for federal income taxes plus state and local income taxes as applicable.
Please note: Roth IRAs are totally different from traditional IRAs, and may be totally exempt from income tax.
ESTATE TAX FOR NONCHARITABLE BENEFICIARIES
Before distributions are made to your beneficiaries, other taxes may be deducted off the top depending on the size of your estate and who is named as the beneficiary.
Caution: New Estate Tax Development Affecting IRA Distributions During Your Lifetime
The American Taxpayer Relief Act of 2012 (ATRA) made estate tax law permanent following more than a decade of constant change. In 2012, estates paid a 35 percent tax after a $5.12 million per-person exemption. These guidelines were scheduled to revert this year to 2001 tax law with a $1 million exemption and a 55 percent top tax rate. ATRA prevented this change and instead indexed the 2011 exemption for inflation — $5.25 million in 2013 — and set a 40 percent tax rate. In 2013, more than 99.8 percent of estates will owe no tax.
GENERATION-SKIPPING TRANSFER TAX ON NON-CHARITABLE BENEFICIARIES
If IRA distributions go to grandchildren or more distant heirs, they may also be subject to the second kind of estate tax, the generation-skipping transfer tax.
Under ATRA, the generation skipping transfer tax exemption has also been indexed for inflation and therefore increased from $5.12 million in 2012 to $5.25 million in 2013, and the maximum generation skipping transfer tax rate has increased from 35% in 2012 to 40% in 2013. These unified exemptions will continue to be indexed for inflation in 2014 and later years.
If income tax, estate tax and generation-skipping transfer taxes all apply, there are special calculations to interrelate them, and the total can be over 75% percent of the IRA going to taxes.
CHARITIES PAY NO TAXES
If the tax bites on your IRAs are too big to swallow, consider naming tax-exempt charities to avoid income tax, estate tax and the generation-skipping transfer tax. The charities will receive 100 percent of your IRAs without any tax reduction.
Traditional IRAs and retirement plans are good candidates for naming charitable beneficiaries. Since Roth IRAs can avoid income tax but not necessarily estate tax, do a separate assessment on your Roth IRAs.
HOW TO BENEFIT CHARITIES AND NON-CHARITABLE BENEFICIARIES AT THE SAME TIME
You may want to split up your traditional IRA assets between charitable and noncharitable beneficiaries. To minimize required distributions during your lifetime — so you have more assets to pass on after your death to loved ones — ask your tax adviser about having a separate IRA for the charity or carving out a separate account for the charity under an existing IRA.
Consider the strategic division of your IRA to minimize income and potential estate taxes. Here is an example: Assume you’re a widower and you have two children who are in the combined 40 percent federal and state income tax brackets. Your $1.8 million estate consists of a $600,000 IRA and a $600,000 house, with the balance in cash and equities that you want to benefit your children and your one favorite charity equally.
Let’s say you leave 50 percent of the IRA and 50 percent of the house to the charity and the same percentages to your first child, while the remaining assets worth $600,000 go to your other child. The charity would receive $600,000 (as they pay no taxes) but your first child would have his share reduced by federal income tax (around $240,000) on the IRA portion. Thus one of your children would receive only around $360,000.
If you instead opted to leave the IRA to the charity, the house to your first child, and the remaining assets to the second child, each would receive $600,000 of assets with no estate or income tax due on their share. Thus your child would benefit by $240,000 more.
Retirement plan beneficiary designations are an important part of your estate planning, and one often ignored or not addressed properly. As there are many complex tax rules associated with them, be sure to check with you advisers, especially if your estate is at, nearing or over $1 million.
CHECKLIST FOR COMPLETING YOUR BENEFICIARY DESIGNATION