We live in a wonderfully philanthropically minded community. When I am doing an estate plan for a client who has a desire to leave a gift to charity, one of the things that I try to accomplish for the client is to make the gift in the most tax efficient way possible.
Most people have a mixture of types of assets in their estate. They have real estate, investments, bank accounts, and usually an IRA or 401k plan. Not all of these assets are created equal when it comes to the income tax system.
Most investments and real estate receive an adjustment to their basis, when they are included in the estate of a decedent. Basis is a tax term that refers to the historical cost of the investment, ie. what you paid for it. Basis is what you subtract from your sale proceeds to calculate what your gain or your loss is. Because real estate and investments fluctuate in value, there is often gain on them at the time of the owner’s death. When the asset is included in the deceased person’s estate, the asset’s basis is adjusted to equal the fair market value of the asset as of the date of death (often referred to as a “step-up”) in basis. This means that the recipients of these assets will have little or no gain on the assets when they are sold. In other words they are virtually free from income tax.
On the other hand, assets held in an IRA or 401k plan do not get a step up in basis upon the owner’s death. When these assets are inherited, and a distribution is received by the beneficiary, every dollar is considered taxable income. However, when the recipient is a 501(c)(3) organization (most charities), they pay no income tax, so the recipient is indifferent to the consequences of receiving a distribution from an IRA.
We can utilize the charity’s indifference to receiving IRA money to the advantage of the client’s other beneficiaries, who are typically family members, by allocating the IRA money to fund the charitable gift, while leaving the other assets to the family members who would otherwise have to pay income tax upon the receipt of the IRA distribution.
While this sounds easy and straight-forward, in practice, it frequently becomes more complicated than expected. Take, for example, a client who wishes to leave ten percent (10%) of his entire estate to charity. This particular client has an IRA that is worth $400,000, real estate worth $250,000 and other investments worth $200,000, for a total estate of $850,000. Ten percent (10%) is $85,000, so the client could just say, I’ll leave $85,000 of my IRA to charity and figure he’s done what he set out to do. However, over time, the value of the assets will be constantly changing, and that fixed dollar gift will not continue to equal ten percent (10%) of his overall estate. Rather than use a fixed dollar beneficiary designation, we would usually recommend that the client’s IRA designate the client’s trust as beneficiary, and then that the gift to charity be made from the client’s trust, using a formula of ten percent (10%) of total value of the estate as the value of the gift. In addition, it is necessary to include a special instruction to the trustee, that the charitable gift must be funded with assets from the IRA, to the extent possible. This accomplishes the client’s intentions, and maximizes the value of the inheritance to the non-charitable beneficiaries.