In some cases, leaving your qualified retirement account to a charity and other assets to your heirs can save on taxes.
An important part of establishing an IRA, 401(k), 403(b) or other qualified plan is naming a beneficiary. On the positive side, this helps ensure that upon your death, any remaining account balance will transfer directly to your heirs without going through probate. On the negative side, your heirs could lose up to 80 percent of the account's balance to income and estate taxes, both federal and state.
On other assets, heirs pay less or even no tax. For example, an inherited home can be sold for its value at the owner's date of death and the heir pays no federal income or capital gains tax, although taxes will be due on any amount over the dated value. Stocks the owner holds outside a qualified account and passes to his heirs receive a step-up in cost basis to the value on the date of death, so heirs pay no capital gains tax on the stocks' appreciation during the original owner's lifetime.
By leaving qualified plan balances to nonprofits and more tax-advantaged assets to your heirs, you have the potential to get more of your wealth where you intended. Nonprofits, being tax exempt, pay no income tax on the money they receive. Proper estate planning can help you avoid a few potential mistakes and decide which method to use for distributing your assets.
Two relatively simple issues can create the biggest problems in a qualified plan bequest to a charity. The first is not specifying the precise organization name on the beneficiary form. If you're an animal lover, putting "Humane Society" on the form will probably result in the account's reversion to your estate and subsequent probate process. You need to list the exact name of the organization, such as "Nebraska Humane Society" and include the organization's tax identification number. Tax ID numbers for many nonprofits can be found at www.guidestar.com.
The second issue involves possession of funds. The account assets must be transferred directly to the nonprofit organization. If your estate or other heir takes possession of the assets and then transfers them or writes a check for the same amount to the organization, income and possibly estate taxes will be incurred. An estate can claim only a partial charitable deduction, leaving more of the assets subject to taxes.
You can choose from a number of methods for getting funds from your qualified plan account to a nonprofit. As mentioned earlier, one of the easiest is to name the charity as the beneficiary on the account forms. For certain types of accounts - including money purchase pension, profit sharing, 401(k), stock bonus, employee stock ownership plans or defined benefit or annuity plans - your spouse must sign a waiver relinquishing his or her right to the account. This rule does not apply to IRAs.
You can also name multiple beneficiaries with a specified percentage of the account for each, or list the charity as the contingency beneficiary. This means that if all other beneficiaries are deceased, the account passes to the charity.
A provision of the Pension Protection Act of 2006 allows IRA holders over age 701/2 to transfer up to $100,000 to a charity without recognizing income tax on the withdrawal. The transfer will meet the minimum distribution requirement, making this an attractive option for those with overfunded IRAs who fear the required distributions will push them into a higher tax bracket. For this rule, which expires on Dec. 31, 2007, private foundations or groups considered supporting organizations under the IRS code do not qualify.
You can also designate a charitable remainder unitrust or charitable remainder annuity trust as the qualified plan account beneficiary. You can designate an heir, who receives the income from the trust on a tax deferred basis over his lifetime. When that heir dies, the principle of the trust passes to the charity. This option may be the most tax-advantaged option if the qualified plan requires an immediate lump-sum distribution upon the account holder's death, because the income tax can be deferred rather than being due in total with the lump sum.
Designating a charity as a beneficiary on your qualified plan account can help protect your estate from state and federal income tax and estate tax. You should consult an estate attorney, tax professional and financial advisor to ensure your estate plan gets your assets exactly where you intended.
Lawrence D. Sprung, CFP of Mitlin Financial Inc., is a Registered Representative with Securities America, Inc., a Registered Broker/Dealer, member NASD/SIPC. Advisory services offered through Securities America Advisors, Inc., a SEC Registered Investment Advisory firm. Lawrence D. Sprung, Investment Advisor Representative. Mitlin Financial Inc. and Securities America are unaffiliated. He can be reached at (631) 465-2017 or by e-mail at email@example.com. Feel free to forward any questions, or future topics you would like to see discussed to firstname.lastname@example.org and put longisland.com in the subject line.