Distribution planning for funds held in qualified retirement plans, IRAs, and tax-sheltered 403(b) annuity contracts (collectively known as tax-favored retirement accumulations) is one of the most active areas for financial and estate planners. Most of this planning does not directly involve charitable giving, because it is directed principally toward income tax deferral and wealth preservation for the heirs of high-net-worth individuals. Many financial and estate planners are unaware of the pitfalls to avoid when a charity is the intended recipient of tax-favored retirement accumulations, resulting in unintended adverse income and estate tax consequences to the owner and heirs.
To complicate matters, charities themselves exhibit a lack of understanding through promotional material urging potential donors to select them as beneficiaries of tax-favored retirement accumulations. Acting on such recommendations can adversely affect the owner and other beneficiaries.
Proper planning can maximize benefits for the owner and heirs of tax-favored retirement accumulations while assuring the charity will receive generous support.
Distribution planning is governed by the provisions of IRC sections 401 (a)(9) (regarding qualified plans) and 408 (regarding individual retirement accounts). Those sections, along with IRS regulations, describe the rules for distribution of taxfavored retirement accumulations. The rules provide that the distribution of such accumulations from the account of an individual who dies before the required beginning date (RBD) must be determined by using the life expectancy of the beneficiary. The RBD for most individuals is April 1 of the calendar year following the year they reach age 701. Exceptions exist for qualified plan participants that 1) made a "TEFRA" or "242(b)(2)" election permitting a delay in commencement of benefits or 2) own no more than 5% of the company sponsoring the plan.
If death occurs before the RBD, any beneficiary can withdraw the funds at any time during the five calendar years following the owner's death. A designated beneficiary (an individual or a qualified trust) can, by withdrawing a minimum amount in the year following the owner's death, extend the distribution period over the beneficiary's life expectancy. If an individual reaches the RBD, the distribution period is determined by the joint life expectancy of the owner and the designated beneficiary.
IRS regulations provide that certain entities-nonqualifying trusts, the owner's estate, and charities-do not have a life expectancy. As a result, the designation of a charity as beneficiary for tax-favored retirement accumulations can have an adverse income tax impact on the owner and beneficiaries because the entire amount of the taxdeferred accumulations becomes income with respect of a decedent to the estate.
Death Before RBD: Charity as Sole Beneficiary
If the owner of tax-favored retirement accumulations dies before the RBD and a charity (or a number of charities) is the sole beneficiary, there will be no tax problem. Because the charity is the direct beneficiary of the funds, the estate tax charitable deduction will avoid any estate tax on the funds. Because the beneficiary pays the income tax on distributions of tax-- favored retirement accumulations and the charity is exempt from income tax, none will be imposed and the charity will have full use of all of the funds. Because a surviving spouse has an absolute right to part of a qualified retirement plan participant's benefits, spousal consent must be obtained when a charity is to be the sole beneficiary in order for the charity to receive the intended amount.
A charity receives the entire tax-- favored retirement accumulation if it is the direct beneficiary, but the same would not be true if the decedent's will directs payment of the funds to a charity and the beneficiary designation provides that the estate is to receive the funds. …