Whether you know it or not, your “estate” is comprised of different assets with different attributes. Some of your assets will be governed by your will, while others will be governed by the beneficiary designation attached to the asset. Some assets you leave to your heirs will be subject to income tax and some will not. When weighing how best to incorporate charitable giving into your estate plan, it makes sense to lean on one specific type of asset to make your charitable gifts: your pre-tax retirement accounts such as a 401k or traditional IRA.
Many people like the idea of giving some portion of their estate to charity, but charitable gifts are often overlooked or put on the back burner during the estate planning process. This happens for a couple reasons. First, the estate planning process can be complex, and many people have a simple goal: just get something in place that will effectively pass assets to family in the most efficient way possible. They leave the charitable giving discussion until some undefined “later” time that doesn’t always materialize. Second, the estate planning process can be expensive. After receiving the bill for the attorney services for the initial estate plan, couples are reluctant to resume the estate planning process any time soon.
But there’s a simple and effective way to include charities in your estate plan by utilizing pre-tax retirement accounts.
Why Pre-Tax Retirement Accounts?
Remember there are different kinds of assets in your estate. From an income tax perspective, your pre-tax retirement accounts are conventionally seen as a less desirable asset to inherit. Of course, any inheritance is a net positive, but pre-tax retirement accounts are subject to ordinary income taxes when the beneficiary takes the assets out of the retirement account. And, since the SECURE Act, a beneficiary generally has just 10 years to remove the assets from an inherited retirement account. So, a pre-tax retirement account is less desirable to inherit, but only for individuals subject to the income tax. Charities don’t pay income tax, so they are unconcerned about the “pre-tax” aspect of the retirement account.
Why is it simple?
An estate plan is usually composed of a will, powers of attorney, and a health care directive. All of those documents are usually drafted by attorneys who charge for both the process and product, as well as any future changes or amendments. But another key component of an estate plan is paying attention to the assets in your estate that have a beneficiary designation attached to them – things like life insurance and (importantly) retirement accounts. Beneficiary designations are not normally changed by attorneys – you change them yourself with the custodian of the asset or account. Usually there is no charge to change beneficiary designations and often you can make changes quickly and as frequent as you would like.
What if assets fluctuate?
Assets can and do fluctuate. Life circumstances change and laws change as well. The result of all this is that your estate plan, and any beneficiary designations that create a gift to a charity, are fluid concepts that change from time to time. But, because beneficiary designations are simple and free to change, you can easily change your mind as frequently as you want and change the beneficiary designation to accommodate the current assets and the current gifting plan.
Consolidated into an Example
Imagine Beau and Diana have two kids and a net worth of $1M which is composed of a house ($500k), cash in banks ($100K), and a retirement account ($400k). Assume they want 10% of the estate going to Charity ABC and the rest to their kids. They could write that percentage gift into the will, or, as discussed above, they could utilize the pre-tax retirement account. Their will would simply say everything goes to their kids (wills don’t generally dispose of retirement accounts that have beneficiary designations). Then, they would update the beneficiary designation on the retirement account to provide 75% to their kids and 25% to Charity ABC. The result is that Charity ABC gets the $100k from the pre-tax assets, preserving more of the nontaxable assets for the kids. And, as assets change, Beau and Diana need only remember to periodically update the beneficiary designation on the retirement account without needing to update the will again or pay attorney’s fees. Assuming the highest marginal tax rates, by utilizing pre-tax assets for the charity, the children will net a higher amount than if other assets (house or cash) were utilized to make the $100k gift to Charity ABC.
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The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
