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A Charity Strategy with IRA and Life Insurance

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The first baby boomers will turn 65 this year with the remaining 75 million reaching that milestone over the next 18 years. Many of these successful individuals have wisely accumulated savings in retirement accounts–either employer-sponsor retirement plans such as a 401k plan or Individual Retirement Arrangements (IRAs). These accounts are income tax efficient during the accumulation phase as contributions are pre-tax and asset growth is tax-deferred.

Unfortunately, they can create significant income and estate tax liabilities upon distribution. This article describes some of the basic tax issues regarding distributions from IRAs (or other retirement accounts) and illustrates some strategies to reduce both income and estate tax liability and maximize gifts to charities.

IRA Distribution Basics

At age 70 1/2 the IRS requires owners of IRAs to begin Minimum Required Distributions (MRDs). These distributions are calculated annually based on the IRA balance and IRS life expectancy tables. The larger the balance and the older you are, the larger the MRD. For example, a 70 year-old with a $1 million IRA is required to take a $36,000 distribution. Assuming IRA assets grow 5% annually, these distributions will increase over the years:

Not only is the IRA owner required to take distributions regardless of personal needs or desires, but the distributions are subject to ordinary income tax rates. Currently, the highest federal ordinary tax rate is 35%; however, it’s not unreasonable to assume higher tax rates in the future. Also, most states impose income tax on IRA distributions ranging from 3% to as high as 10%.

Unfortunately, income taxes may not be the only tax liability associated with IRA accounts. Depending on future estate tax legislation and one’s personal situation, IRA assets may be subject to an estate tax (currently 35% and most recently 45% in 2009). Assuming a 35% rate, a $1 million IRA could yield a $350,000 estate tax liability.

In addition to this estate tax liability, IRA beneficiaries are still required to take distributions and pay income taxes on those distributions. It’s not difficult to picture a scenario where an IRA could generate a 60% – 70% effective tax rate considering both income and estate taxes. The result is that a $1 million IRA could generate over $600,000 of tax liability, leaving less than $400,000 million to heirs.

If paying a 70% tax is not appealing to your clients, you could suggest the following strategies.

Gifting Strategies

A simple, but effective strategy to limit taxes at death is to name a charity as the IRA beneficiary. This gift will eliminate both income and estate tax liabilities associated with the IRA at death. As beneficiary, the charity will receive the entire IRA balance not eroded by taxes. Please note that this strategy assumes heirs will inherit a suitable amount from other assets.

Naming a charity as beneficiary recognizes significant tax savings at death; however, income taxes are still due every year on the Minimum Required Distributions. This annual tax liability can be mitigated by with a corresponding tax deductible gift to the charity.

To further enhance your ultimate gift, the charity can allocate the annual donations to a life insurance policy on both the IRA owner and spouse’s lives. Using the Minimum Required Distributions, the charity could secure a guaranteed life insurance policy with a $3.13 million death benefit.1 This strategy offers both current income tax relief and a significant future benefit to the charity.

IRAs and other retirement plans can be wonderful vehicles to save and accumulate assets, but present a myriad of unpleasant tax issues upon distribution. Fortunately, charitable individuals can implement strategies that eliminate most, if not all, of these taxes and impart significant benefits to their favorite charities.

Walt Helms, CFP, EA, is vice president of case design at Nease, Lagana, Eden & Culley, Inc., Atlanta, Ga.