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The combined estate and income taxation of an IRA, Keogh, or 401(k) plan at death can be severe -- 80% in many cases. One solution is to combine a wealth replacement trust with naming a charitable beneficiary for the retirement account. This strategy frequently results in a win/win/win situation for the owner of the retirement account, the heirs, and a favored charity. This article examines the details of this technique.] Testing Financial
Tolerance For Charitable Bequests Of IRAs Gifting an Individual Retirement Account ("IRA"), Keogh, or 401(k) to a favorite charity at death (referred to below as a Charitable IRA) is a very generous act - so generous, apparently, that most people don't think they can afford to do it. But is that perception accurate? Let's look at evaluating the alternatives - including comparing the technique to a so-called Stretch-Out IRA. Note: This article takes a transactional approach to the clients' planning issues in that it focuses solely on solving problems associated with an overfunded IRA. The article in this series entitled Testing Financial Tolerance for a Zero Estate Tax Plan examines a much more comprehensive approach. Case Study Background: Nathan and Greta Baier are age 65 and 60 respectively. If they were both to die today, their estate would total almost $12,000,000 (plus $1,000,000 of irrevocable trust-owned life insurance). You can examine the breakdown of all their assets on the Client Information Summary that appears in Figure 1. On that Summary, you can see they have a fairly diversified portfolio which includes $5,000,000 of stock in a family-owned business (which they assume will grow in value by 5% a year). Part of their asset base includes Nathan's IRA currently valued at $1,600,000 which is expected to yield 10% a year. In Figure 2, you can see it is a superb living asset; however, Figure 3 shows it to be a real tax magnet at death since the combination of estate and income taxes produces an effective tax rate in the area of 80%. Nathan and Greta want $200,000 a year in spendable cash flow in their retirement years -- increasing by 3% a year as an inflation offset. The analysis runs until their ages 95/90 and, over this term, they will require cumulative after tax cash flow of $9,515,084. The Analysis: In this evaluation, Strategy 1 involves preparing a Status Quo scenario to determine if the Baiers' current asset base can support their desired retirement lifestyle. This is then compared to a Strategy 2 scenario in which the Charitable IRA planning technique is introduced. Basically, this approach compares a benchmark (the Status Quo) to an alternative (in this case, a Charitable IRA) and allows the Baiers to make their decision in a comparative environment. It addresses the fundamental step that most wealth preservation plans miss -- "How does doing it compare to not doing it?" In both Strategy 1 and Strategy 2, we will illustrate minimum distributions from their IRA, the so-called "Pension Last" technique; however, to avoid the confiscatory tax bite at death, Strategy 2 will assume the beneficiary of their IRA is a favorite charity.
Since the death proceeds of the IRA are shown going to a charitable cause in the Strategy 2 analysis, we have included in Strategy 2 the purchase of $1,600,000 (the current value of their IRA) of survivor universal life insurance (non-variable, level face amount) in an irrevocable wealth replacement trust. The trust's annual premium for this policy is illustrated at $15,000 a year -- well within the Baier's annual gift exclusions. The graphic below compares the results. There are three possible beneficiaries of any asset: 1) Family; 2) Charity; 3) IRS. With proper planning, you get to pick two. The Baiers have decided to disinherit the IRS -- at least insofar as their IRA is concerned. In the upper left of the graphic, notice how insignificantly the Baier's living net worth is reduced by the gifts to the trust for the life insurance premium. And, of course, there is positive impact on the illustrated inheritance to their heirs shown on the lower right. Is it worthwhile? Before you decide, examine the potential bequest to the charity on the lower left! The Strategy 2 alternative should be a very easy choice. Clearly, the charity has been substituted for the IRS. Stretch-Out IRAs: Is a Charitable IRA better than a so-called Stretch-Out IRA? We believe it is since the Charitable IRA not only can result in a substantial charitable gift, but the substitute proceeds paid to heirs via the life insurance policy: 1) are out of the estate and 2) have a 100% cost basis in the hands of the heirs. The Stretch-Out IRA does not avoid estate taxes on the death of the IRA holder, and the inherited IRA has a $0 cost basis. As discussed previously, we scheduled minimum distributions from the IRA, and this causes the IRA values to hit a high point of slightly over $5,000,000 (see Figure 2). With a Stretch-Out IRA, if the last-to-die of Nathan and Greta were to occur at this point (the most favorable scenario for this Stretch-Out IRA example), the income tax could continue to be deferred on the $5,000,000 in IRA values but not the estate tax of approximately $2,800,000.
As an alternative, we added a Strategy 3 to the Charitable IRA analysis where we increased the life insurance to $5,000,000 (level face amount with an annual premium of $50,000) so the heirs can inherit a sum equal to the highest projected value of the IRA -- as they would with the Stretch-Out IRA (but only if the last death occurs late in the game). The results are shown below: Notice how insignificantly the Strategy 3 Charitable IRA impacts the Baier's living net worth (upper left) while retaining the same potential charitable bequest as Strategy 2 (lower left); however, Strategy 3 adds a significant increase to their heirs' inheritance (lower right). With this approach, the entire $5,000,000 in life insurance proceeds passes intact to the heirs containing a cost basis of $5,000,000, i.e., it becomes a capital account. Even taking into account the premium for the life insurance, a Stretch-Out IRA doesn't even come close to this result since, even after paying estate taxes on the IRA of approximately $2,800,000, the heirs are left with income tax deferred assets still trapped in an IRA. Furthermore, the Stretch-Out IRA remains subject to all the burdensome IRA tax regulation while the heirs' capital account created by the life insurance death benefit in the Charitable IRA arrangement does not. And, of course, with a Stretch-Out IRA, the charity receives nothing. Have we overlooked the power of the ongoing income tax deferral of a Stretch-Out IRA? No -- if this is desirable, the $5,000,000 in life insurance proceeds can be placed in a deferred annuity, thereby achieving similar tax deferred results while 1) retaining its $5,000,000 cost basis and 2) eliminating the heavy hand of government IRA regulation. Will a Charitable IRA approach work with smaller estates? The answer is an unqualified Yes. So long as taxes impact pension assets at death, the Charitable IRA strategy can produce exceptional financial results. I vote for the Charitable IRA, how about you? Frequently Asked Questions About Charitable IRAs: Can a spouse be designated as beneficiary ahead of the charity? The charity is named as the ultimate beneficiary. The surviving spouse is typically named as primary beneficiary since this avoids income tax at the death of the IRA owner as well as estate taxes (due to the unlimited marital deduction). When the surviving spouse dies, the charitable beneficiary designation becomes operational. Can a charitable beneficiary designation be revoked? Yes, since it isn't an irrevocable beneficiary designation, it can be changed at any time before death. What if estate taxes are repealed? Is there a need for a Charitable IRA? Yes, since most of the tax on an IRA is income tax, a Charitable IRA would continue to be worthwhile. In addition, if estate taxes are repealed, the repeal will be phased in over several years, and there is no assurance they won't be reinstated by future politicians. Finally, as indicated above, the entire transaction could be revoked prior to death should future circumstances dictate. Are there restrictions on accessing IRA funds during the lifetime of the Baiers? No -- the IRA funds are freely accessible at any time prior to death. Can different charities benefit from the funds? Yes. One of the easiest ways to do this is to make the charitable beneficiary a "donor-advised" account at a public operating charity. Many Community Foundations offer this option although the funds must usually be distributed only to local charities. For more flexibility, consider charitable organizations that offer this service on a national and international basis. Two organizations that do this are:
Conclusion: The Charitable IRA provides a compelling planning opportunity, and we recommend you include it in your arsenal of wealth preservation techniques. Working With Charities: Most charitable organizations do not know how to make a convincing case for naming themselves beneficiaries of an IRA. You can help them do so convincingly with a Charitable IRA presentation. Illustration Data: We used our InsGift System for this evaluation. (InsGift is also the source of the graphics above). Space prevents us from including all the reports generated by the system; however, InsGift users can review reports and related menu inputs by downloading the InsGift Workbook named ChIRA.!IG from the Workbook Download section of this website. (On our home webpage, click on Producer's Center, then click on the Workbook Download icon at the top of the next page). After downloading the Workbook, you can import it into your InsGift System by clicking on Client Workbook/Import Workbook on the Main Toolbar of your InsGift System. To download the Workbook now, click here. If you are not licensed for InsGift and would like more information, please contact an InsMark Account Executive at 1-888-InsMark (467-6275), or click here. Computer Business Card: InsMark has recently released a Charitable Pension Computer Business Card ("CBC") in a PowerPoint format that follows the logic of this article. CBC licensees are authorized to make unlimited copies for distribution to clients and/or advisers. For CBC licensing information, contact an InsMark Account Executive at 1-888-InsMark (467-6275), or click here. Members of InsMark's Power Producers Marketing Group receive the Charitable Pension CBC on a complimentary basis. Note: In all cases, the approval of legal and tax advisers must be secured before any variation of a Charitable IRA is utilized. |
