Charitable Planning with IRAs

Americans held $7.4 trillion in assets in individual retirement accounts (IRAs) as of the end of March 2016, making IRAs the largest component of the U.S. retirement market.¹If you're interested in using some of the assets in your IRA to support worthwhile charitable organizations, you'll want to pay attention to the tax ramifications of doing so, which will vary depending on how the donations are structured.

IRA Distributions During an Investor's Lifetime

You might think that you can withdraw money from an IRA and then offset what would be a taxable distribution with a charitable deduction. However, this is often neither feasible nor financially sound. Consider the following: 

• Most IRA withdrawals made before age 59½ are subject to a 10% early withdrawal penalty, even if the funds withdrawn are donated to charity.
• The charitable deduction for cash contributions is generally limited to 50% of the taxpayer's adjusted gross income (AGI). IRA distributions to charities that exceed this limit may result in the loss or deferral of this deduction.
• If you're a high-income earner, some itemized deductions are phased out due to what's referred to as the "Pease" limitation, named for the legislator who sponsored the provision. This may reduce the value of your charitable contributions. This limitation comes into play if your adjusted gross income is  $311,300 or more for married couples filing jointly or $259,400 or more for those filing as single.²  Your deductions will be reduced by the lesser of 3% of the amount by which your AGI exceeds these limits, or by 80% of the itemized deductions that are affected by this limit.
• In states that don't allow an income tax deduction for charitable contributions, IRA distributions will be subject to state income tax without any offsetting charitable deduction.
• Large IRA distributions must be recognized as taxable income, which could increase your AGI. Higher AGI may result in the loss of several valuable income tax deductions, including the medical deduction, the casualty-loss deduction, and miscellaneous itemized deductions. A higher AGI may also limit your ability to use the personal exemption. It could also mean an additional 3.8% surtax on net investment income — this applies if your AGI is more than $250,000 (for married couples filing jointly) or more than $200,000 (for those filing as single).

A Charitable IRA Rollover

The Protecting Americans from Tax Hikes (PATH) Act of 2015 allows individuals who have reached age 70½ to make tax-free distributions up to $100,000 from a traditional or Roth IRA directly to one or more qualified public charities (which does not include donor advised funds or most private foundations). Unlike previous legislation —originally enacted as part of the Pension Protection Act of 2006 and extended multiple times — the current legislation is "permanent," in that there is no expiration date. A charitable IRA rollover distribution is not included in the IRA owner's income, but it still counts toward the owner's required minimum distributions. Due to the phase out of itemized deductions and the alternative minimum tax, a charitable IRA rollover could be a much more tax-efficient way of making a lifetime gift.In addition, per Internal Revenue Service (IRS) Notice 2007-7,  an IRA distribution to a qualifying charity in which the IRA owner has an outstanding pledge will be treated as a qualified charitable distribution, not a prohibited transaction.³

Naming a Charity as a Beneficiary of an IRA

Designating a charity as a beneficiary of your IRA can offer several benefits:

• The donation qualifies for the federal estate tax charitable deduction, so there's no estate tax incurred.
• Neither you nor your estate have to pay any income tax on the funds.
• The charity does not need to pay tax on the proceeds.
• You do not need to amend your will or trust agreement to change the beneficiary of your IRA.

The IRA's beneficiary designation form governs who will receive the IRA assets after you die. If you're a high net worth investor, you can benefit by working with a financial institution that accepts customized IRA beneficiary designations.

Using a Charitable Remainder Trust to Receive the IRA at Death

If you're looking to both support charities and benefit family members after your death, you may find a charitable remainder trust (CRT) to be a tax-efficient solution. With a CRT, your heirs could receive a steady income stream from the trust for their lifetimes, or for a set period of years. A CRT also serves to postpone (but not avoid) income taxes on the IRA assets, which provides an additional benefit to your heirs.  Because a CRT is exempt from income taxes as a charitable trust, the receipt of the IRA by the CRT will not require the payment of any income tax. When the trust is terminated, the remaining principle is distributed to the charities.To qualify as a CRT, the trust must meet the criteria set forth in Internal Revenue Code (IRC) Section 664, which stipulates in part that the present value of the charitable remainder interest must be at least 10% of the net fair-market value of such property transferred in trust, on the date of transfer. Additionally, the annual distribution must be no less than 5% and no more than 50% of the initial net fair-market value of the trust assets.⁴

Until recently, low interest rates made lifetime CRATs possible only in certain limited circumstances. Only individuals who were in their 70s or older could take advantage of a CRAT for life. Younger beneficiaries were limited to terms of fewer than 20 years.However, on August 9, 2016, the IRS created a new "safe harbor" for CRATs created on or after that date. This allows for all individuals regardless of age to utilize a CRAT for life (or the lives of both the individual and the individual's spouse) as long as the trust agreement includes a trigger provision that says the trust's assets will be immediately distributed to the remainder beneficiary if the CRAT's assets ever fall below 10% of its initial value (multiplied by a discount factor). If the CRAT's investments outperform the IRC section 7520 rate that's in effect when the CRAT is created (1.4% for September 2016), the early termination would not be triggered.Also, while no federal income tax is imposed on payment of the IRA to the CRT, it may be subject to state or federal estate tax, as the charitable deduction is limited to the actuarial value of the remainder interest.  Moreover, if an IRC Section 691(c) charitable deduction for estate taxes is available, it may be more tax efficient for an individual beneficiary to receive an outright distribution rather than a CRT.⁵

Conclusion

While IRA charitable gifting strategies can offer significant tax advantages, strategies that utilize other types of assets may be more tax efficient. For instance, your tax liability may be lower when you donate property that has a low basis and large, built-in capital gain. Shares of stock or real estate often fit this description. Before implementing any charitable gifting strategies, review the impact on your overall wealth plan and consult with your wealth, legal and tax advisors.

¹Investment Company Institute, Retirement Assets Total $24.1 Trillion in First Quarter 2016, June 23, 2016

²Internal Revenue Service, IR-2015-199, In 2016, Some Tax Benefits Increase Slightly Due to Inflation Adjustments, Others are Unchanged, October 21, 2015

³Internal Revenue Service, Miscellaneous Pension Protection Act Changes, Notice 2007-7

⁴ Internal Revenue Code,  26 U.S.C. 664 - Charitable Remainder Trusts

⁵Internal Revenue Code, Section 691, Recipients of income in respect of decedents