If you want to leave something to charity when you pass away and you have a traditional IRA, naming a charity as an IRA beneficiary is an excellent strategy. Under current tax law, your IRA balance will be included in your estate for federal estate tax purposes. If you pass away with a taxable estate that exceeds the exemption from federal estate tax, the balance in the IRA will be subject to tax to the extent your estate exceeds the exemption. Beginning January 1, 2013 the federal estate tax exemption will be $1 million. Whether or not the exemption will be raised with new tax legislation is anyone's guess.
Not only is the IRA subject to estate tax, but the IRA proceeds payable to beneficiaries are "income in respect of a decedent" for federal income-tax purposes. That means that withdrawals taken from your IRA by your individual beneficiaries will be taxed as ordinary income to them at rates that could run as high as 36.5%. These beneficiaries can get a deduction for estate tax paid; but it is a deduction, not a tax credit. So the combined rate of taxation considering both estate and income tax is about 58.7%.
In Pennsylvania, IRA withdrawals are not subject to Pennsylvania income tax. However, the IRA balance is subject to inheritance tax when you die if you are over age 59-1/2. If the IRA passes to your children and grandchildren, the inheritance tax rate is 4.5%. That brings the total tax rate up to 63.2%.
The tax policy behind the tax advantages of an IRA during your lifetime is to encourage you to save for retirement. After you die, the income tax that was deferred must be paid; and if you have a large enough estate, your estate will pay estate tax. Tax policy is that IRAs are for retirement income, not for wealth transfer at death.
If you were already planning on leaving part of your estate to charity, consider using the IRA to make this gift. There is a charitable deduction for the federal estate tax so that 100% of any sum going to charity passes free of federal estate tax. Also, charities are income tax exempt. When the charity receives the IRA as a beneficiary, no income tax is payable. Neither is the IRA subject to PA inheritance tax when paid to a charity. The charity, unlike your children and grandchildren, will receive 100% of the IRA. Then you can leave other assets that aren't taxed so brutally to your heirs -- which means more after-tax cash for them. The charity and your family beneficiaries get more; the government gets less.
How should you leave benefits to charity?
The simplest and most effective way is to designate a charity as the primary beneficiary of your IRA. This technique also works if you want to leave the IRA to several charities. A group of charities can receive fractions or percentages of the benefit, all free of income tax and estate and inheritance tax.
You need to be very careful if you name a person and a charity as co-beneficiaries within the same IRA. Many planners recommend dividing the IRA and having the charity as sole beneficiary of one IRA and your individual beneficiaries on the other IRA. Why?
Generally, the Internal Revenue Code allows the beneficiaries of an IRA to withdraw the benefits in annual installments over the life expectancy of the designated beneficiaries. A charity does not qualify. Individual persons who are beneficiaries can use the life expectancy method but a charity cannot. Furthermore, individual persons can only use the life expectancy method if ALL beneficiaries of the IRA are individuals. If a charity is one of a group of beneficiaries, then all beneficiaries must take a lump sum.
There are two ways that the individual could still get the opportunity to stretch out the IRA payments even if a charity is part of a group designation:
1. If the group of beneficiaries' interests are expressed as fractional or percentage shares, and the beneficiaries establish "separate" accounts for their respective shares in the IRA by December 31 of the year after the year of the IRA owner's death, then each separate account is treated as a separate IRA for distribution purposes. The obvious drawback of this approach is that the beneficiaries have to meet the deadline for establishing a separate account. (This, of course, assumes that the beneficiaries or the professional advisors know that a separate account is necessary and why.)
2. The other exception is that a beneficiary is "disregarded" if the beneficiary's interest in the IRA is completely distributed by September 30 of the year after the year of the participant's death. Thus, if the charity's share is paid out before the deadline, the remaining beneficiaries would be entitled to use the life expectancy method. Again the drawback is that time passes quickly and people miss deadlines, or people are unaware of the problem until it is too late.
If making sure that the beneficiaries can use the life expectancy payout method is an important goal, it is not recommended that you make a group designation that includes a charity for a portion. Instead, separate the IRA, and make a separate account that is wholly payable to charity. The individual beneficiaries can be beneficiaries of the other IRA. You can rebalance occasionally by moving funds from one IRA account to the other if the balances change or you change your mind about how much you want to give to charity.
One account you don't want to leave to charity, however, is your Roth IRA. Instead, you should leave Roth IRA balances to your individual beneficiaries by designating them as the account beneficiaries. All withdrawals taken by your beneficiaries are free from federal income tax. If you leave Roth IRA money to charity, this valuable tax break goes to waste.