Often Overlooked Estate Planning Opportunity

Many in the financial and estate planning fields focus primarily on managing cash flow during their clients’ lives and minimizing their estate taxes. However, we believe there’s an ancillary planning tactic that’s often overlooked but could be a compelling option when an individual passes away: enhancing the potential impact of charitable contributions with certain retirement plan assets, such as Individual Retirement Accounts (IRAs) and 401(k) accounts. Although such retirement plans cannot be tax-efficiently transferred to charity during a person’s lifetime, as discussed below, when done at death it may provide for income tax savings.

The effort to maximize charitable dollars is not new. In fact, it’s been a focus for individuals and families who are currently committed to charitable causes (including the many who have signed the Giving Pledge), as well as pioneering wealth creators like the Carnegie and Rockefeller families, who were among the first families subject to the estate tax when it was introduced in the early 20th century.

As we’ll explain, families who hope to fulfill philanthropic endeavors through their estates can take advantage of this estate planning strategy that maximizes funding charitable causes while, in some cases, simultaneously reducing estate taxes.

Why it could pay to flip the script

If you’re like many affluent individuals, you probably haven’t considered the monetary benefit of bequeathing your retirement assets to charitable causes. Frequently, when formulating an estate plan, affluent individuals have an initial preference to bequeath cash and its equivalents to philanthropy, while assigning their spouse or children as the beneficiaries of their retirement assets, such as IRAs and 401(k) accounts.

Because most traditional retirement plans have yet to be subject to income taxes—and will generally not be until they’re withdrawn—they have often grown in value to comprise large portions of one’s estate. Further, retirement accounts held in an estate do not receive a step up in income tax basis to their fair market value. This means that noncharitable beneficiaries must treat distributions in the same manner as the participant would have if they were still alive (i.e., as ordinary income).

On the other hand, charitable organizations are generally exempt from income taxation, including distributions from retirement plans. These factors combined are compelling reasons to overcome the misconception that retirement assets are best used for family bequests, when in fact, it’s often best to leave retirement assets to philanthropic recipients.

Demonstrating the value in New York City and non-tax states

The following example demonstrates the potential magnitude of “flipping the script” for an individual with a gross estate that far exceeds their lifetime exemption amount, and assumes no growth and income in the retirement account after the person has passed away. In a hypothetical scenario where both the decedent and the inheritor live in NYC, where the retirement account will be subject to both estate and income tax, gifting a retirement account to charity saves close to $4 million on a retirement account of $10 million. The following examples assume the individual had intended to bequeath $10 million of assets to charity at death.

Example provided for educational and illustrative purposes only.  Actual results may vary and are dependent on an individual’s financial situation. Please see disclosures for more information. * This illustration uses top federal, NYS and NYC income tax rates and assumes lifetime exemptions were previously utilized.

Consider that the above analysis shows the estate and income taxes on a $10 million retirement account would be almost $8.9 million, leaving the inheritor barely more than $1 million. Since the entire $10 million could be given to charity with $0 estate and income taxes, consideration should certainly be given to a philanthropic allocation.

For those who reside in non-tax states, such as Florida, the financial impact isn’t as pronounced, but may yield a meaningful economic outcome. The example below demonstrates that the incremental amount of taxes by providing a $10 million retirement account to a family member would be about $2.2 million (as opposed to roughly $3.9 million in the example above).

Example provided for educational and illustrative purposes only.  Actual results may vary and are dependent on an individual’s financial situation. Please see disclosures for more information.
* This illustration uses top federal tax rate and assumes lifetime exemptions were previously utilized.

What about Roth IRAs?

Unlike traditional IRAs and 401(k) accounts, Roth IRAs will not be subject to income taxes when distributed to beneficiaries. Accordingly, Roth IRAs are may be an attractive option to consider for family bequests.

It doesn’t have to be “all or nothing”

All retirement accounts require a beneficiary designation, which identifies where the funds in the account will go—be that to individuals or charitable organizations—when the account owner passes away. More than one beneficiary may be identified to receive portions of the account, so designating various beneficiaries, including charities, could be a viable estate planning strategy when determining desired allocations.

Currently, allocating all or a portion of the account balance to charity is as simple as changing the beneficiary designation on file with the financial institution. It’s not only possible to change the allocation, which often occurs as an individual’s wealth evolves over time, but there’s no limit on the number of parties that can be identified, nor is there a limit on how often you may make such changes. In contrast, implementing a similar change of beneficiary in your will can be challenging.

We’ve also seen families change their allocations in order to empower their younger generations to oversee future philanthropic activities, and some have even seeded family foundations in advance to start the process sooner.

Taking action: What are your options?

To implement a charitable beneficiary designation (full or partial), it’s important to consider the options available. There are generally three distinct options, as well as a combination of the three. Here is a quick summary of these options:

1. Private family foundation: Suitable for those who wish to create a legacy to ensure their name, charitable mission and philanthropic goals live on. Investment income is currently taxed at only 1.39%,¹ and annual granting of 5% of the foundation’s assets is required.
2. Donor-advised fund (DAF): Designed for those who do not want to take on the administrative responsibilities a private foundation requires, and who may want to donate anonymously. DAFs, taxed as public charities, are not subject to the 1.39% investment income tax, and do not require annual granting.
3. Direct donation to public charity: Likely best for those with a clear understanding of the exact organizations they’d like to support financially.

Make the most of your estate assets

Since affluent individuals need to allocate substantial financial assets when estate planning, the decisions you make can be highly consequential. According to one study of the affluent², retirement accounts alone may comprise over half of overall wealth. Another survey³, meanwhile, showed that ultra-high-net-worth individuals are now responsible for almost 40% of all individual charitable giving, which may be done efficiently with traditional retirement plans while eliminating their inherent income tax liabilities.

Estate planning can undoubtedly involve some fraught talks, entailing discussions about mortality and wealth distribution. However, it can help to reframe the conversation to focus on the potential for savings that can accrue through proactively putting smart tax strategies in place, as doing so may help to provide long-term financial security, for your family and heirs.

If you’d like to evaluate if your estate planning blueprint best reflects your wishes, in the most tax-advantaged manner possible, a Corient Wealth Advisor can help and, as needed, also engage the services of a tax advisor specialist (should you not be working with one already). Don’t hesitate to connect with us.

¹ https://www.irs.gov/charities-non-profits/private-foundations/tax-on-net-investment-income-of-private-foundations-reduction-in-tax#:~:text=For%20tax%20years%20beginning%20after%20December%2020%2C%202019%2C%20all%20private,tax%20using%20the%201.39%25%20rate.
² How Do You Achieve a High Net Worth? | Empower
³ 'Dollars up, donors down': More charity money comes from ultra-wealthy

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