Making Charitable Gifts From Retirement Vehicles
Retirement savings options have changed dramatically since individual retirement accounts (IRAs) were created more than 30 years ago. For many individuals, IRAs and similar vehicles such as 401(k), 403(b), and Keogh plans remain popular ways to help prepare for a comfortable post-career lifestyle by postponing tax payments on earnings while you work. They also can be a valuable part of a charitable giving program.
For such plans, you will face tax costs when you eventually start taking distributions, in many cases as required minimum distributions (RMDs) at age 70½. Depending on your tax situation, you could face a sizeable tax bill because distributions from these accounts are taxed as ordinary income, possibly at a rate as high as 35%.
IRA distributions for charitable purposesAs part of the Emergency Economic Stabilization Act of 2008, signed into law on October 3, 2008, the option for individuals older than age 70½ to directly roll funds from an IRA to a qualified charity was extended. Known as the charitable transfer or rollover, this donation and tax strategy first appeared in 2006. The new law continues this option through 2009.
Eligible IRA holders can continue to directly transfer from their retirement accounts up to $100,000 that otherwise would be taxable income. This move is most beneficial to older traditional IRA account holders, who must take at least required minimum distributions. By transferring those required withdrawals to a charity, they saved on taxes because much of the money in such accounts is eventually taxable at ordinary income tax rates, which could be as high as 35%.
Making charitable donations directly from your IRA also could be used by Roth IRA account holders. For these individuals, such a transfer would be worthwhile if the Roth had income that would have faced tax when distributed (e.g., the account was not held the requisite five years to allow tax-free withdrawals of earnings).
Since these types of distributions are tax-free, you cannot deduct the gift. But the ability to keep the money out of your taxable income can offset this deduction loss.
IRA rollover gifts cannot be directed to foundations, donor-advised funds, or supporting organizations. Individuals must take a taxable withdrawal form the IRA and then can contribute that amount to the foundation, donor-advised fund, or supporting organization. As with any other income, you can reduce the taxable amount of your retirement income by claiming deductions. If your tax situation is such that it is beneficial to you to itemize deductions, then donations you make to qualified organizations will increase your deductions and should reduce your tax bill.
Just be sure that you keep in mind the various limitations on deductions, especially those that relate to a donor's adjusted gross income.
The situation is different if your retirement money is in a Roth IRA. You are not required to take RMDs from a Roth and the total amount of your withdrawals (under most circumstances) will be income tax-free.
If your Roth distributions are your only income, then you probably have no tax bill. But if, in addition to your Roth funds, you have other income that is taxable, you might want to consider donating Roth distributions to a charity as a way to reduce taxes on your other taxable retirement income. No income taxes will be due and you may claim the entire amount of the transfer as a charitable income tax deduction, subject to IRS limitations.
When a company establishes a retirement plan for its employees, it must meet IRS guidelines; in doing so, it becomes a qualified plan. For you, the most important aspect of a qualified plan is its tax-deferral feature: taxes are typically due on contributions and their earnings only when withdrawn.
Some qualified company plans allow employees to purchase company stock to add to their retirement accounts. If you have such securities that have appreciated while in the plan, you might be able to take advantage of this special tax arrangement and donate the stock to a charity.
This is allowable as long as you (or your beneficiaries) are eligible to take a lump-sum distribution (as defined by the IRS) of the account within a single tax year. This lump-sum distribution can only be taken without penalty once you reach age 59½ unless due to a "qualifying event," such as becoming disabled, retiring, or leaving the job—either voluntarily or otherwise.
You or your beneficiaries may elect to use a tax-advantaged net unrealized appreciation (NUA) strategy upon lump-sum distribution of an account that contains appreciated securities. Your NUA is the difference in the appreciated value of the company stock in excess of what you paid for it. You must pay income tax on the cost basis of your stock at your ordinary tax rates upon distribution (an additional 10% penalty will apply if you are under age 59½) and the NUA will be taxed at the long-term capital gains rate (currently a maximum of 15%) when the stock is sold.
Caution: If you or your surviving spouse chooses to roll over some or all of the stock into a Traditional IRA, when the stock is distributed from the IRA it will be taxed at ordinary income tax rates based on the market value at distribution.
After you have withdrawn your appreciated stock from the plan (and paid taxes on the cost basis), you could donate some or all of your appreciated stock to charity. By doing this, you will receive a charitable income tax deduction equal to the fair market value of the stock and will not recognize any long-term taxable gain at the time you donate the shares.
This example illustrates how this process works:
An individual receives a lump-sum distribution of 1,000 shares of employer stock from a 401(k) plan with a cost basis of $4 per share. The current market value is $10 per share. The stock has appreciation of $6,000. The recipient can elect to have this treated as NUA and then donate this stock to charity. The charitable donation deduction for the year would be $10,000 and the recipient would not have to pay tax on the stock's appreciation.
| Elect NUA Strategy and Donate (Long-Term) Appreciated Employer Stock to Charity | ||
|---|---|---|
| Current Market Value | $10,000 | |
| Basis | $4,000 | |
| Net Unrealized Appreciation (NUA) | $6,000 | |
| Income Tax Due | ||
| Cost Basis x 25% Federal Tax Rate | $1,000 | |
| Capital Gains Tax Due | $0 | |
| Total Income Taxes Due | $1,000 | |
| If the stock is donated to charity: | ||
| Charitable Deduction Amount | $10,000 | |
| Tax Deduction | $2,500 | |
| ($10,000 Contribution x 25% Ordinary Income Tax Rate) | ||
| If the stock is sold and the proceeds donated to charity: | ||
| Capital Gains Tax Due | $900 | |
| ($6,000 Capital Gains x 15% LTCG Tax Rate) | ||
| Charitable Deduction Amount ($10,000—$900) | $9,100 | |
| Tax Deduction | $2,275 | |
| ($9,100 Contribution x 25% Ordinary Income Tax Rate) | ||
| Capital Gains Tax Due | $(900) | |
| Net Tax Deduction if Sold | $1,375 | |
| Net Tax Advantage of Donating Stock | $1,125 | |
This special tax treatment is not applicable to appreciated stock in a Traditional IRA account. All pretax contributions and investment earnings in such an account are subject to ordinary income taxes when distributed, as discussed earlier.
When it comes to retirement accounts, the tax concerns surrounding the money do not necessarily end when you pass away.
Retirement account money left to anyone other than your spouse is known as income in respect of the decedent (IRD). The IRS defines this as all income that the account holder would have eventually received had death not occurred. It includes retirement account balances at the time of death, including unrealized appreciation and income accrued to date of death, minus any nondeductible contributions. (Some people put money into a Traditional IRA even when they cannot deduct the contributions. This generally occurs when you have a retirement account at work but also contribute to a Traditional IRA. In this case, you cannot deduct your IRA contributions if you earned over a certain threshold amount.)
Your spouse can escape IRD complications by rolling over an inherited lump-sum company retirement account or IRA into another Traditional IRA. But if the account beneficiary is someone else, some or all of the lump-sum distribution from the inherited account may be taxable, both at the federal and state levels. Even with recent changes in federal estate tax laws (which could change again in coming years), the combined taxes could be quite onerous.
Action Idea: So your heirs won't face taxes on your retirement fund, you may wish to consider leaving other assets to them and bequeathing your IRA to a charitable organization.
To avoid such tax problems, you might want to consider leaving other assets (for example, stocks that will transfer with a stepped-up basis) to your heirs and bequeathing your retirement account balance to a charity or a donor-advised fund that will ultimately distribute your excess retirement money to a qualified organization.
The advantage of leaving a retirement fund to a charity is that your estate will receive an estate tax charitable deduction for the amount donated. And the charity, which does not have to pay taxes, will have full use of your retirement account proceeds.
It is usually easy to leave the balance of a retirement account to a qualified charity. The charity to which you want to leave the money should have information and documents to start the process. You'll also need to advise your plan administrator and complete the appropriate paperwork required by the financial institution holding your retirement account. Depending upon which kind of retirement account you have, you'll also need to check on any rights your spouse might have to your plan. In most cases, he or she will have to give written approval for you to name someone else as beneficiary.
In addition to getting your spouse's approval, be sure to talk with the rest of your family so that everyone knows, and is comfortable with, your retirement account bequest wishes.
