If you’re like many Americans, you have a great deal of your wealth tied up in traditional IRA accounts. Why? The tax-free benefits motivated you. But there’s going to come a time when you will have to pay taxes on this money. One tax-saving strategy that you can consider is to designate your favorite charity or charities as beneficiaries of all or a portion of your IRAs. Then you can leave other assets to family members and other heirs.
Here’s how the taxes on IRAs that you leave to your heirs work:
- Traditional IRA accounts are included in your estate for estate tax purposes when you die. (Estate tax only applies if your total estate is worth more than 5.49 million dollars in 2017) This is tax No. 1.
- The taxable portion of the IRA balance — often the entire amount — is counted again as “income in respect of a decedent,” or IRD, for federal income tax purposes. Therefore, federal income tax will be owed when your heirs make IRA withdrawals. This is tax No. 2.
- To make matters worse, state income tax may be due as well. (This is not the case for PA and many other states that do not tax retirement income.) Tax No. 3.
After all these taxes have been paid, your heirs may receive only a fraction of your IRA money. This is why a tax-savvy solution is to leave some or all of your IRA to charitable beneficiaries while leaving other assets to heirs of your choice. The net result will be more after-tax cash for them. And you will be satisfying your own charitable intentions.
Name one or more tax-exempt charitable organizations as beneficiaries of your IRA to leave that money to charity. Under our current federal tax system, this is the only way to leave IRA balances directly to charity.
One important thing to note here is that leaving your IRA to a charitable organization does not stop the requirement to make required minimum distributions until you pass away. The IRS forces you to cash out a portion of your IRA and pay taxes on it each year after you reach 70 and 1/2. So unfortunately, you will be forced to pay taxes on a piece of your IRA every year after 70 1/2 until you pass away.
As an alternative, you can take money out of your IRAs now, pay the resulting income tax and then give cash to the charitable organizations. Your contributions are fully deductible for income tax purposes, although income-based restrictions could limit your charitable write-offs. Charitable contributions are itemized deductions, so keep that in mind when deciding to pursue this strategy. You may have to claim your deductions over several years, or you may be better off claiming a big portion at one time. Consult your accountant for help determining the best strategy to pursue.
The bottom line is that leaving money directly to charities when you pass by designating them as account beneficiaries is very tax-efficient, but it only applies to the money that remains in your IRS.
This strategy allows you to leave more to your favorite charities AND more to your loved ones while keeping as much as possible from the IRS.
One final word, however. This information generally applies to traditional IRAs. Naming a charity as the beneficiary of your Roth IRA is generally inadvisable. Leave Roth balances to your loved ones by designating them as account beneficiaries. Why? As long as your Roth IRA has been open for more than five years before withdrawals are taken, all withdrawals will be federal income tax-free. But if you leave Roth IRA money to charity, this tax break is wasted.
The bottom line? Talk to a qualified financial professional about your charitable goals and any traditional or Roth IRAs you have in order to take care of both your family and your designated nonprofits in as efficient a way as possible.
