Charity Minefields in Estate Planning

#estateplanning #trustplanning #trusts 401k assets attorney advice charity ira north carolina stocks tax-deferred accounts Jan 16, 2023

Giving to charities through gifting and estate planning can provide may rewards, and not just a good feeling knowing you are helping others. There are plenty of tax breaks that can come along with being charitable. However, there are also several minefields that can unintentionally hurt you and your loved ones if the transition isn't handled properly, as well as a few powerup strategies to really boost your estate. By not just giving, but giving the right way, everyone (except the government) benefits.

The three main classifications of transfers are 1) gifts of items or amounts, 2) bequests of items at death, and 3) bequests of a percentage at death. We'll cover the different types of accounts and provide the pros and cons. 

Cash Gifts: Probably the simplest of gifts, charities usually appreciate cash gifts the most. From the charity's perspective, this is the easiest to handle since it goes directly into their bank accounts, and they can put the money to work. It's also the easiest for you to transfer to them simply by transferring it. No selling, no extensive paperwork, just a gift with corresponding deductions from income taxes.

When it comes to bequests upon death, there are a few potential charitable deductions. First, there are the same potential income tax deductions on the deceased person's final tax return. In addition, charitable transfers on death also reduce the taxable estate, potentially savings approximately 40% of what otherwise would be subjected to estate taxes.

Stocks: Stocks can be an incredibly effective gift to a charity depending on the cost basis (purchase price). When a stock is purchased at a certain price, goes up substantially in value, and then is sold, it is subject to capital gains taxes. Let's use an example where someone is told by their accountant that they need $10,000 in charitable deductions. They have available $40,000 in a bank account, but they also have a brokerage account containing 100 shares of XYZ Company, Inc. The shares are currently valued at $100 per share (total of $10,000 value), but they only paid $2 per share when it was still a very young company.

So what should they do? Take $10,000 from the bank account and give it to the charity? Sell the stock and give the $10,000 to the charity? No on both counts. The cash is just cash. Selling the stock means they have to pay the capital gains taxes, which means they have to pay the tax on top of the money received for the stock. On the other hand, if they gave the stock to the charity and let them sell the stock, then there would be no capital gains taxes since 501c3 charities do not pay taxes. So what do they get in terms of taxes and deductions?

* The full $10,000 deduction their accountant was looking for

* It cost them $10,000 in stock, BUT

* It saved them a tax bill for capital gains taxes in the range of $1,470-$1,960 by not selling the stock

While this is an out of the ordinary example of a stock appreciating in value, any stock value increases have potential capital gains taxes associated with selling that stock down the road. However, no one would have to pay that tax if the stock were gifted to a charity which then sold the stock. 

Real Estate: Among the clients I have worked with over the years, very few have left real estate in a Trust or Will to a charity just to get a tax deduction. Usually there is a specific purpose for the real estate and deductions are only a possible bonus for them. In one case, a client was leaving real estate to a church that was located across the street to assist with the church's expansion. In another case, a woman was leaving a house to an animal shelter to be used as a secondary location for cats should there be additional space needed (and in exchange for the shelter caring for her two cats in the house for the remainder of their lives).  When leaving a charity a real estate bequest, it allows the typical deduction of the fair market value of the house from estate taxes. However, the house and land, like all assets under current federal estate tax laws, would not have any capital gains taxes since the cost basis increases to fair market value on the date of death. So unless the house were sold much later (typically a year or more) and the value increased, there wouldn't be any capital gains taxes anyway.

However, it is a whole new ballgame when it comes to gifts of real estate during life. You can give land, a house, or commercial building to a charity and not pay any taxes. However, you are now losing the entire value of property with nothing in return but the deductions. One way is to gift real estate to a charity, especially commercial property that has been highly depreciated, is through a Charitable Remainder Trust, also called a "CRT." A full Charitable Remainder Trust strategy can:

* Provide for charitable deduction for the value of the "end of the day" donation to the charity spread out over five years

* A stream of income (taxable) over a period of years

*  Fund a life insurance policy to replace the value of the building to your heirs

This concept of a CRT with replacement life insurance is too much information to fit in one blog, but look for a webinar in the near future.

Life Insurance: Probably one of the simplest ways to leave money to a charity is naming it as a beneficiary on a life insurance policy, either in whole or in part. However, life insurance can be one of the least tax-favorable assets to leave to a charity. Since there are no income taxes on life insurance, the only benefit of leaving life insurance to a charity is to decrease the potential estate tax liability. Depending on your state, this might be a high number your estate might not be likely to reach. If you are in North Carolina like my estate planning clients, then there is no state level estate tax, and the federal estate tax limit is $12.92 million. In addition, cash from a life insurance policy may be needed more for immediate expenses.

However, some of my clients and their charities will prefer to have an additional, separate life insurance policy that is specifically dedicated to going to the charity, and they may have additional life insurance for their estate. In this case, they are not taking away any life insurance to provide it to the charity, but instead are providing for the charity and loved ones in separate life insurance policies.

Percentage of Estate: Probably the most popular and flexible ways to provide money to charities through an estate is to provide a percentage of the estate, and the most common is 10%. This is especially true for churches and other religious houses of worship in the form a "final tithe" to support their faith. But why is this flexible? It's because it is typically allocated through a Will or Revocable Living Trust along with the other beneficiaries, which is after debts, expenses, and taxes are paid. So no matter how great or small an estate is, the percentage comes out along side the other beneficiaries.

The alternative to a percentage of the estate could be a dollar amount, and that is far from flexible. If the estate ends up being considerably smaller at the time of death compared to the time of setting up the estate plan, then the charity could end up getting more than the beneficiaries. At the same time, if the assets have grown significantly since the time the estate plan was put in place, it could end up being a relatively small amount in relation to the total estate going to the charity. This could lead to more amendments and adjustments to an estate plan, and more legal fees, whereas the percentage is consistent with the size of the estate.

Retirement Accounts: IRAs, 401ks, and other tax-deferred accounts can be the most dangerous of assets to leave a charity upon death if not handled properly. On the one hand, leaving a retirement account to a charity means that all of the accumulated income taxes do not have to be paid since the charity is exempt, and there can be other potential tax benefits. On the other hand, leaving the charity a percentage of a retirement account can be a tax disaster for the other beneficiaries since they will not be able to take advantage of the ten year "stretch" of the income taxes through an inherited IRA. The best they can do is a five year, even payout.

Let's use an example to illustrate. If Jane Smith wants to leave her IRA as 30% to child 1 John, 30% to child 2 Jenny, 30% to child 3 Jim, and 10% to her church, then all three children must withdraw (and get taxed) over a five year period, and the charity gets it's 10% without any taxes. On the other hand, a better tactic is to "split" her IRA so that 10% is in one IRA and the other 90% is in another. The 10% IRA lists the charity as the only pay on death beneficiary. The 90% IRA lists the three children as equal beneficiaries. Here's what happens:

* The charity gets the 10% without any income taxes.

* John gets his 1/3 of the 90% IRA, and he plans to take the money out evenly over ten years, keeping him in a lower tax bracket each year.

* Jenny is in sales, and she gets significant bonuses in good years but has much lower income in bad economic years. She can take more money out in the lean years but less in the good years, provided all of the money is withdrawn and taxed by the end of year ten.

* Jim is nearly in retirement already, so he is planning on taking more out in the initial years and deferring starting his social security so that he can come out even between the inherited IRA withdrawals and social security kicking in.

By simply naming a charity as one beneficiary alongside other "people" beneficiaries, you can potentially be giving an increased tax burden to your loved ones. By planning the beneficiaries on retirement accounts the right way, both the charities and the family can come out ahead in terms of taxes.

There are many reasons to include charities in both gifting each year and in estate planning. But there are worlds of tax opportunities, and a few minefields to avoid. So how you do your charitable planning may be just as important what you give.

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