Estate planning can seem complicated, and trying to decide what to leave to charity and what to leave to individuals can be confusing. Layer on tax considerations, and the process can be overwhelming. However, the good news is if we break it down into simple steps the process is not so daunting.
Once you decide you want to leave money to charity, the first step is to determine which accounts are best to leave to individuals and which are good for charitable bequests. When creating your estate plan, you will need to think about all your assets: your personal items, bank account, home equity, brokerage account, and retirement accounts. Interestingly, these assets have different tax treatment when your heirs receive them, making some assets better to leave to individuals and some better to leave to charity.
To demystify this, we first need to understand how investment and retirement accounts are different. An investment account is a brokerage account that you fund with after-tax money, and it receives capital gains tax treatment. Retirement accounts, on the other hand, can be broken down into two types: tax deferred and Roth. With tax deferred retirement accounts (e.g., 401(k), IRA Rollover, etc.), you do not pay tax on the money you put in, and you defer paying taxes until you take the money out in retirement. Roth accounts are a little different. You pay taxes on the money you contribute, but the growth is tax free when you take it out in retirement.
These accounts also receive different tax treatment when your heirs receive them. The key point is minimizing the taxes your heirs will owe maximizes their inheritance.
To pass a larger inheritance to individuals, we want to inherit accounts that result in less income tax. Previously, I wrote about the importance of saving in a brokerage account. (Government executives and professionals, this is especially important for you. See our class on retiring from federal service for more information.) The key point is brokerage accounts are good for both you and your heirs. When your heirs receive them, the cost basis is stepped up to the fair market value on the date of death. This means your heirs will not owe income tax on the growth generated over your lifetime.
To illustrate, let’s say over your lifetime you invested $100,000, and it was worth $300,000 at your passing. During your lifetime, $100,000 was the cost basis, and you had $200,000 of growth that would have been taxable to you. At your passing, the cost basis becomes $300,000, and your heirs do not owe income tax on the $200,000 of growth that occurred during your lifetime. Since your heirs inherit the growth tax free, brokerage accounts are best left to individuals.
Now, let’s look at retirement accounts. As I mentioned before, you do not owe taxes on Roth accounts when you take the money out in retirement, and your heirs will not owe income tax either. This makes Roths great vehicles to pass money to the next generation, and it is best to leave Roth accounts to individuals rather than to charity.
With tax deferred retirement accounts, there are rules covering when you and your heirs have to take distributions. Since the rules covering required minimum distributions for both you and your heirs are complex, we will save that conversation for another day. The important thing to know is every dollar taken out of a tax deferred retirement account is taxed at ordinary income rates. This means the inheritance your heirs receive from a tax deferred retirement account will be reduced by the income tax they pay. While individuals will owe tax on distributions from an inherited IRA, that is not the case for charities. If you leave money from your IRA to charity, the charity does not owe income tax on it. Since you did not pay income tax on either your contributions or the growth, the money given to charity avoids taxation completely. That makes tax deferred IRAs good vehicles if you want to include charitable giving in your estate plan.
To accomplish this, list a charity as a beneficiary on your IRA. The charity can be either a primary or contingent beneficiary, and you do not have to leave all of your IRA to charity. You can leave some to charity and the rest to individuals. However, it may be best to have the amount you want to leave to charity in its own IRA. Also, you do not need to name the charity in your estate documents (i.e., your will or living trust). The beneficiary designations on your IRA will control who receives the money. If you later change your mind and want to change the amount you leave to charity, or leave the money to a different charity, all you have to do is update the beneficiary designations.
Creating an estate plan centered around your goals and values can be confusing, but breaking the process down into manageable steps is one way we help clients achieve their goals.
Apella Capital, LLC (“Apella”), DBA Apella Wealth, is an investment advisory firm registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered or excluded or exempt from registration requirements. Registration of an investment advisor does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Apella Wealth provides this communication as a matter of general information. Any data or statistics quoted are from sources believed to be reliable but cannot be guaranteed or warranted.