By Victor Colella, CFP
As an advisor to individuals and families, we often find ourselves talking with our clients about their legacy. This typically starts with a simple but difficult question: When they’re gone, how would they like to impact their loved ones, their communities, or causes that they care about? You can likely imagine where the conversation goes from there — we talk through their feelings about gifts to their family, whether they want to leave anything to the charities or causes they support, and even how they want their pets to be cared for. These conversations about their mortality usually get to the core of what’s important in their life, and often become critical guideposts to help them get the most out of their financial assets.
After we’re clear on their objectives, we help clients identify the best way to structure their assets and estate plan to (1) ensure their legacy is realized, and (2) to maximize the impact of their resources through tax planning and other considerations related to their different account types.
When clients have a diversity of account types with significant assets, a few simple planning concepts can really make a big difference. One example of this would be an individual who has a substantial portion of their assets in a brokerage account (after-tax), a Roth IRA (tax-free), and a traditional IRA (pre-tax). I’ll be focusing this article on what types of gifts are particularly beneficial to come from a traditional IRA relative to a Roth IRA or brokerage account. The following list describes several instances where traditional IRA’s shine when it comes to gifting.
You want to avoid probate, but don’t want to deal with creating a trust or implementing other probate-avoidance methods.
This benefit is sometimes overlooked when it comes to IRAs (and also applies to most other account types where you can name a beneficiary). If you designate a beneficiary on your IRA, then at your passing, the assets will flow directly to your beneficiary or beneficiaries without your loved ones needing to navigate your state’s probate process. All states are different, but probate can get expensive and is rarely the way a grieving loved one wants to spend their time.
It is critical that you have at least one living beneficiary on the account. If this is your spouse, then we emphasize adding contingent beneficiaries as well, or designating the beneficiary as “per stirpes” (which translates to “by branch” in Latin and means that if the listed beneficiary passes before the account owner, then their share of the assets automatically passes to their lineal descendants). In the absence of a valid beneficiary, the account assets can end up in your estate and ultimately flow through probate unnecessarily, so make sure you keep your beneficiaries updated!
One of your intended beneficiaries is a charity or 501(c)(3) organization
If part of your legacy includes charitable giving, this strategy really shines. When clients come to us and want to pass some portion of their estate on to charities or other 501(c)(3) organizations, we often will recommend utilizing IRAs as a key part of that gifting strategy. There are several reasons for this.
First, and most importantly, when a charity receives a gift from an IRA, they are the only type of beneficiary that does not need to pay taxes on the dollars received, at any point. All other beneficiaries will eventually need to pay income taxes on those dollars. The specific rules around when individual beneficiaries must pay taxes on those dollars can get complicated, but generally, if you’re not the spouse of the deceased or a minor, you will likely need to take taxable withdrawals from the IRA over the 10 years following the year the account owner died. Spouses get to essentially assume the account as their own and take distributions according to life expectancy based required distribution rules. When a trust is the beneficiary, the rules get even more complicated, so we won’t go there for now.
The power of the simple fact that charities don’t have to pay tax on IRA gifts is best illustrated with a quick example.
Two friends, Susan and Diane pass away on the same day, both with $1 million. Each has $500,000 in an IRA, and $500,000 in a brokerage account. Both friends want their kids to receive ½ of their assets, and their favorite charity to receive the other ½ of their assets.
Susan gives ½ of each account to her kids, and ½ of each account to her favorite charity. Her kids receive $250,000 of brokerage assets, which they don’t have to pay taxes on (due to a step-up of tax basis at their mom’s passing) and $250,000 of IRA assets, which they’ll likely need to pay income taxes on over the subsequent 10 years. For simplicity, if the kids paid an average federal tax rate of 22% on the IRA dollars, they would have received $445,000 after income taxes (not including any state or local taxes). The charity also received $500,000 in total gifts, and was able to keep every dollar due to their tax-free status. The total amount that went to Susan’s intended beneficiaries was $945,000.
Diane, on the other hand, had already read this article before making her estate plan. She heard that it’s best to use her IRA for all of her charitable gifts, and use her after-tax dollars for her children. She passes 100% of the brokerage account to her kids, and 100% of the IRA to charity. Due to her children receiving a step-up in cost basis on her brokerage account assets, they’re able to keep all $500,000 of their inheritance without needing to pay taxes. The charity was also able to keep every dollar of their $500,000 gift due to their tax-free status. The total amount that went to Diane’s intended beneficiaries was the full $1 million.
Due to a simple change in how Diane structured her beneficiaries and estate plan to prioritize her IRA for charitable gifts, she was able to maximize the impact on her beneficiaries (and directly on her children) by $55,000. That’s a valuable benefit for something as easy as changing your beneficiaries!
You want to maximize flexibility in your legacy plan, and minimize the administrative burden of updates.
When it comes down to it, it’s easier to update the beneficiary on your IRA (or Roth IRA) than it is to change your will, trust, or other estate planning documents to reflect changes in your intended beneficiaries. Nothing can replace a well-crafted estate plan from an attorney you trust, but we often help our clients design their estate plans so that if their beneficiaries change frequently, we’re minimizing the number of times they need to amend trust documents and wills by using IRAs and other accounts with beneficiaries. We have many estate attorneys who we work closely with, and the good ones recognize the power of this simple strategy. However, if your attorney is trying to maximize their hourly fees, they might not be the first to suggest simplifying future updates in this way.
Very often, this compliments a charitable gifting strategy from someone’s IRA. Some folks have charities that fall in and out of favor over time, and replacing “Charity A” with “Charity B” becomes as simple as completing the custodian’s beneficiary change form. This also works well with friends and family. Sometimes one child has a greater financial need than another child, or the children will receive unequal amounts in the estate in order to make up for uneven gifts to one child during their lives. This is all possible through the beneficiaries on your IRA accounts. Some IRA custodians will even allow a “Letter of Instruction” (LOI) to be placed on file for your beneficiaries. This LOI allows you to get more specific than just percentages for your beneficiaries. An example would be language that says to pass the first $100,000 to one individual and to split the remainder 50/50 between two charitable or other beneficiaries.
Another strategy that works very well for some folks is splitting one IRA into two separate IRA accounts. You would do this to increase your control over the amount of your assets that pass to a specific beneficiary, and easily be able to adjust that amount over time without adding the complexity of an LOI beneficiary. For example, you would make one IRA your “charitable IRA” with all charitable beneficiaries, and your other IRA your “family IRA” with all beneficiaries as individuals in your family. A reason to do this would be to make sure you can easily adjust the amount that passes to either group. Some people feel very strongly that they want to leave only so much to family or charity, and when IRAs are invested and their values fluctuate, it becomes easy to accidentally give more or less than you intended at your passing. This strategy can help you combat that fluctuation very easily.
To conclude, I’ll summarize our general advice on the subject simply. Traditional IRAs are best to gift to charities, if possible. Roth IRAs are best to gift to your family or loved ones, because those dollars are not only inherited tax-free but have the potential to remain tax-free and growing for a number of years before they lose their “Roth” tax treatment. Your brokerage account assets are somewhere in-between. Charities that receive brokerage account assets can sell the assets without any tax consequences. For loved ones and family members that inherit brokerage account assets, there isn’t an immediate tax burden. Rather, if assets in the account are subsequently held, grow and are sold, then capital gains and other investment taxes could be owed. Understanding these various principles and rules can help you to maximize the impact of your financial resources as you seek to craft a legacy that supports the people and causes that are most important to you.
About the author: Vic Colella
Victor Colella, CFP®, is a financial advisor in Chapel Hill, NC at the independent, fiduciary, wealth management firm Woodard Financial Advisors. The team at Woodward Financial Advisors works predominantly with female financial decision makers and their families, academics at our prestigious colleges and universities, and many of the corporate executives who call central North Carolina home.