In this Wealth Planning Update:
In this month's Wealth Planning Update, we take a look at the potential tax consequences associated with Income in Respect of a Decedent (IRD), inherited income that will pass through to the recipient or estate and is subject to income tax during that tax year. This tax can have a significant impact on the inheritance received by your beneficiaries so we will discuss how certain strategies can potentially reduce the impact of this tax. In addition, we will explore how these strategies may benefit you from an income perspective.1
The potential impact of IRD
You may be aware that the current estate tax exclusion amount is $5 million (currently adjusted for inflation to $5.45 million in 2016) per individual and that a 40 percent tax (the "Estate Tax") is levied on any dollar amount in excess of this exclusion amount.2 You may not be aware that the amount your beneficiaries will receive may be reduced by another layer of tax due to a concept known as IRD. This tax is, in effect, a tax on any income that was generated by your assets during your lifetime on which you haven't paid any tax. Examples of IRD include qualified retirement plan assets, Traditional IRA distributions, unpaid interest and dividends, salaries, wages, commissions, etc.
IRD is includable both in your gross estate (and therefore subject to estate tax) and is also income that must be included on the estate's income tax return (and therefore subject to income tax). IRD items, along with other estate assets, are eventually distributed to the beneficiaries of your estate and, as such, IRD is generally taxed at your beneficiaries' ordinary income tax rates.
To better illustrate the impact of this additional layer of tax on IRD assets, let's look at a hypothetical example: Mr. Smith has a net worth of $13 million, including an IRA of $2 million. This amount is over the estate tax exclusion amount for an individual (currently $5.45 million in 2016), and as a result Mr. Smith's beneficiaries will face a federal estate tax liability of approximately 40 percent of $7,550,000 3, including the IRA assets. When the beneficiary receives the IRA, the assets are still in a pre-tax account. The distributions will be subject to ordinary income tax rates as high as 39.6 percent (depending on the recipient beneficiary's tax bracket) as the IRA is depleted. The end result is that as much as 79.6 percent of the IRA may be diminished by a combination of estate and income taxes.4, 5
So what can be done to help address this tax impact on your current income as well as the potential income of your heirs? Well, for those individuals already taking Required Minimum Distributions (RMDs), you can take action now to potentially lessen your tax bite for 2016. And anyone who has charitable intentions can also take action by structuring their estate plan appropriately.
Charitable giving – Addressing your income taxes now
First, let's look at what can be done in 2016. Many are aware that most charitable deductions provide a corresponding tax deduction. However, if you are over age 70 ½ and taking the annual RMD from your retirement accounts, you may have an option that allows you to make RMDs directly to charities up to $100,000 annually. If you are charitably inclined, making a Qualified Charitable Distribution (QCD) allows you to satisfy RMD requirements without recognizing the distribution in your gross income. Note that you may not "double dip"—that is, if you elect to make a QCD, you do not also receive a charitable income tax deduction for your gift.
Charitable giving – Addressing potential estate taxes
As IRAs and other qualified retirement plans can make up a significant portion of the wealth of many individuals, if you are charitably inclined, these assets could be an option to be donated to charity at death. Generally speaking, charities do not pay income taxes and would keep every dollar received as a result of completed gifts of IRD assets. In addition, a bequest of IRD assets can create both an estate tax charitable deduction and an income tax charitable deduction for the estate.
Referencing Mr. Smith again, the chart below compares the potential estate and income tax implications of the following situations. The scenario on the left (titled "Un-Planned") reflects net worth of $13 million, including an IRA of $2 million, with no charitable planning. The middle scenario ("$2mm Gift to Charity") reflects net worth of $13 million, including an IRA of $2 million, with a $2 million charitable bequest of cash upon death. The scenario on the right ("$2mm IRA to Charity") reflects net worth of $13 million, including an IRA of $2 million, with a charity named as the beneficiary of the IRA.
Source: Wells Fargo Wealth Planning. The analysis assumes IRD assets are taxed at the highest marginal bracket of 39.60%. The analysis assumes the individual dies in 2016. Recall that the federal lifetime exemption amount for 2016 is $5,450,000. The $475,200 difference between the "$2mm Gift to Charity" scenario and the "$2mm IRA to Charity" scenario is that the distribution is done as a beneficiary designation, not a bequest. State death taxes and estate administration expenses are not accounted for in the analysis.
As you can see from this hypothetical example, it could be more tax-efficient for a charitably-inclined individual to use his or her qualified retirement assets to fund any charitable objectives. The potential tax savings can increase as the amount of the gifted qualified retirement assets increases.
As we have previously alluded, there are many ways in which you can give to a charity. Your gifting strategy can be as simple as a direct contribution during your lifetime or it can include more complex strategies such as creating a trust as part of your estate plan. While this Wealth Planning Update will focus on some of the testamentary options explored and explained in further detail below, as a general rule a charitable contribution funded from an IRA or qualified retirement plan typically does not put a donor in a "disadvantaged" tax position.
When comparing the options of including a specific bequest to a charity or changing the beneficiary designation of a qualified retirement plan, an individual with significant qualified assets may be better served by changing the beneficiary designation of such assets to a charity (or a Donor Advised Fund). As highlighted in the hypothetical examples above, the overriding reason is the potential reduction of the payment of income tax on the IRD assets (as much as a 39.6 percent tax savings) but there are other potential advantages as well.
By contributing via beneficiary designation, the donor has the opportunity to (1) keep his charitable contributions private (as Wills are generally public documents), (2) avoid probate fees on the assets going to charity and (3) potentially saves on legal fees by not having to have estate planning documents redrafted to include the charitable bequests.
Charitable giving – Addressing goals
Maybe you have charitable intentions but also want to benefit your heirs. There is a third option to consider – a split-interest trust. A "split-interest trust" is just that – a trust that is split into two interests. This means that the income from the trust is first dispersed to the beneficiaries of the trust for a specified time period and then the remainder is donated to a designated charity. This can help a variety of goals including the potential reduction of capital gains taxes, increased income and reduction of federal income taxes.
Some common types of split-interests trust that are employed as part of the estate planning process are Charitable Remainder Trusts (CRT) and Charitable Lead Trusts (CLT). CRTs distribute income for a specified time period (at least annually) to one or more beneficiaries and , when that specified time period runs out, the remainder is paid to one or more charitable beneficiaries. A CLT provides income to one or more charitable beneficiaries for a set period of time (that can be measure by a specified number of years, a life of an individual or both) and – at the end of this time period – the remainder is paid to a non-charitable beneficiary or back to the grantor. Each scenario has its benefits and considerations so it's important to involve your attorney, tax advisor and any other advisors in discussions about structuring the trust appropriately to reflect your intentions.
In conclusion, any charitably inclined individuals may want to look to their qualified retirement assets and IRAs to help them achieve their donative intent. Whether it is a QCD6 during an individual's lifetime or a testamentary charitable lead trust funded with qualified retirement assets, using these assets may help achieve the donor's goals in a tax-advantaged fashion. Alongside your attorney and tax advisor, we can talk to you about the different options that may be appropriate for your specific circumstances. We are happy to help you begin these planning discussions.
1 Wells Fargo & Company and its affiliates do not provide legal or tax advice. Tax Planning services are limited to the analysis of various federal and state income tax, wealth transfer tax, and tax-efficient investing strategies. Estate Services provided are limited to administration and settlement services. Please consult your tax and legal advisors to determine how this general information may apply to your own specific situation.
2 IRS Rev Proc 2015-53 https://www.irs.gov/pub/irs-drop/rp-15-53.pdf
3 Not including any applicable estate tax deductions and assuming such individual have not used any of his/her lifetime gift tax exemption.
4 This does not include the benefit a beneficiary may receive because of the IRD Deduction under Internal Revenue Code Section 691(c).
5 "Understanding the IRD Deduction That Inherited IRA Beneficiaries Often Miss," Michael Kitces at Nerd's Eye View, https://www.kitces.com/blog/understanding-the-irc-section-691c-income-in-respect-of-a-decedent-ird-deduction-for-the-beneficiary-of-an-inherited-ira/
6 A QCD permits annual direct transfers to a qualified charity totaling up to $100,000 of tax-deferred IRA savings.
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