Many financial advisors and estate planning practitioners focus primarily on managing their clients' lifetime cash flow and minimizing their estate taxes. However, a helpful planning tactic—and one that's often overlooked—is maximizing charitable contributions with certain retirement plan assets, such as individual retirement accounts and Internal Revenue Code section 401(k) accounts. , when an individual dies. Although such retirement plans cannot be tax-efficiently transferred to charity during an individual's lifetime, as explained below, they can provide significant income tax savings when transferred after death.

The effort to maximize charitable dollars is not new. It has been a focus for individuals and families currently committed to charitable causes (including more than 225 who have signed Giving the pledge), as well as early wealth creators such as the Carnegie and Rockefeller families (who were some of the first families to be subject to the wealth tax when it was introduced in the early 20th century).

Families hoping to fulfill philanthropic endeavors through their estates can benefit from this estate planning strategy that maximizes funding for charitable causes while minimizing estate taxes.

Compelling Economic Benefit

When formulating an estate plan, wealthy individuals often prefer to bequeath their cash and cash equivalents to philanthropy while designating their spouse or children as beneficiaries of their retirement assets, such as IRAs and 401(k) s.

Because most traditional retirement plans must still be subject to income taxes—and generally won't be until they are withdrawn—they are often increased in value to include large portions of your client's wealth. . Further, retirement accounts do not receive a step-up in the income tax basis of their fair market value in an asset. This means that non-charitable beneficiaries must treat distributions the same way the participant would if they were alive, that is, as ordinary income.

Charities, on the other hand, are generally exempt from income tax, including distributions from retirement plans. These combined factors are compelling reasons to overcome the misconception that retirement assets are best used for family bequests, when in fact, retirement assets are often better left to philanthropic beneficiaries.

Value in New York City and non-taxable states

The following example shows the proportions of the “scenario change” for an individual with a gross estate that far exceeds their lifetime exclusion amount and does not assume growth and income in the retirement account after the client has died. In a scenario in which the decedent and heir live in New York City, where the retirement account will be subject to estate and income taxes, donating a retirement account to charity saves approximately $4 million in a retirement account of 10 million dollars.

The analysis above shows that the estate and income taxes on a $10 million retirement account would be $8.9 million, leaving the heir just over $1 million. Since the entire $10 million can be given to charity with $0 in estate and income taxes, consider a philanthropic distribution.

For clients residing in non-tax states, such as Florida, the financial impact is not as great, but still provides a significant economic result. The example below shows the incremental tax amount providing a $10 million retirement account for a family member would be $2.2 million (as opposed to $3.9 million in the example above).

Roth IRAs

Unlike traditional IRAs and 401(k)s, Roth IRAs will not be subject to income taxes when distributed to beneficiaries. Therefore, Roth IRAs are absolutely worth considering for family bequests.

Designation of various Beneficiaries

All retirement accounts require a beneficiary designation, which identifies where the funds in the account will go when the account owner dies, whether to individuals or charities. More than one beneficiary can be identified to take part of the account.

Therefore, allocating all or part of the account balance to charity is as simple as changing the beneficiary designation on file with the financial institution. Not only is it possible to change the division, which often happens when an individual's estate evolves, but there is also no limit to the number of parties that can be identified or the frequency of changes that can be made. In comparison, making a similar beneficiary change in your client's will is more complicated.

We've also seen families change their divisions to empower their younger generations to oversee future philanthropic activities and even seed family foundations in advance to start the process faster.

Three Options

To implement a charitable beneficiary designation (full or partial), it is imperative to consider the options. There are generally three options, including a combination of all three. Here is a quick summary of these options:

1. Private family foundation: Ideal for those who wish to create a legacy to ensure that their name, charitable mission and philanthropic goals live on. Investment income is taxed at only 1.39%, and an annual donation of 5% of the value of PF assets is required.
2. Donor advised fund: Preferred for those who do not want to take on the administrative responsibilities that an FP requires and may wish to donate anonymously. DAFs, taxed as public charities, are not subject to the 1.39% investment income tax and do not require annual gifts.
3. Direct donation to public charity: Best for those who have a clear understanding of the exact organizations they wish to support.

No laughing matter

The high stakes ensure that this is no laughing matter because the sums involved are substantial. According to in a recent study of the wealthyRetirement accounts account for just over half of total wealth. Another surveymeanwhile, it showed that very high net worth individuals are now responsible for almost 40% of all individual charitable giving, which can be done efficiently with traditional retirement plans by eliminating their inherent income tax liabilities .

Mark Rubin is Managing Director, Chief Tax Officer, Geller Tax and Laura Williams is Chief Tax Officer, Geller Tax