12-Jul-17
Bequest of Retirement Assets to Donor-Advised Fund
Take-Away: The owner of an IRA or qualified plan account, e.g. 401(k) account, can designate a donor-advised fund as the beneficiary for those taxable assets. The bequest will qualify for a federal estate tax charitable deduction
Background: A donor-advised fund is classified as a public charity. IRC 501(c)(3). It receives contributions from an individual donor, retains them in a separate account, and distributes those funds to other tax-exempt charities at a later date. Donors, or in the case of a bequest, other individuals who are identified by the deceased donor in their bequest, then “advise” the donor-advised fund which charities should receive the distributions from the separate account. Note that the donor-advised fund is not obligated to follow the directions of the donor or the individuals who are given the authority to “advise” the fund. The donor-advised fund is often thought of as a ‘poor man’s’ family foundation, since usually family members are designated to provide the directions for distributions to charities that the family members select.
Sponsors of donor-advised funds can adopt specific rules or restrictions, so no one donor-advised fund is administered the same as another. For example, some donor-advised funds require that gifts or bequests to a separate account must be distributed from the separate account to charities within a specific period of time, e.g. within 10 years. Other funds require that the charitable gift distribution must be of a minimum value, e.g. $2,500 per charity. Donor-advised funds often charge different fees to administer and invest the separate account from which distributions are made over the years. Consequently, it is best if a client considers making a bequest to a donor-advised fund obtain in advance a copy of the rules and restrictions associated with that fund, so the client fully understands what restrictions or limitations will apply when the fund is “advised” to make distributions to tax exempt charities.
Benefits: As with any gift of retirement assets to a charity, the benefit is primarily that the charity, which is a tax exempt entity, does not pay income taxes on the distribution of the retirement account assets to it. In contrast, if an individual inherits the retirement account, that individual must include the distribution in that individual’s taxable income for the year of distribution, potentially moving the individual into a higher marginal income tax bracket, or possibly causing the loss of income tax deductions, or exposing the individual beneficiary’s income to the net investment income tax (NIIT) of 3.8%. Consequently, for an individual who wishes to make charitable gifts in their estate plan, using retirement assets to fulfill that charitable gift is a smart way to go. It is better for individuals to inherit non-retirement assets from the decedent and charities to inherit retirement assets from the decedent; this results in each receiving more assets than would otherwise be the case, i.e. the individual does not have to pay income taxes out of an inherited non-retirement asset [which will have its income tax basis stepped-up to date-of-death value, thus eliminating exposure to capital gains taxes], while the charity does not have to pay income taxes from the inherited retirement assets as it is a tax exempt entity.
Cautionary Points:
- Study the Fund Restrictions: As noted earlier, each donor-advised fund adopts its own rules, restrictions and fees. An individual who wants to bequeath their retirement assets to a donor-advised fund should confirm that the selected fund will honor any particular requirements or restrictions that the individual wishes to impose on “advised” distributions from the separate account to be established on their death, e.g. permissible delays in “advising” a gift distribution from the separate account for several years; prescribed minimum amounts for each “advised” distribution from the separate account; the identity of qualifying charities that are eligible to receive “advised” distributions from the separately maintained account. Probably the best solution would be for the individual to establish a donor-advised fund while they are alive to fully understand these rules and restrictions and see how the donor-advised fund works in the real world.
- Name a Contingent Beneficiary: Since a donor-advised fund adopts its own set of rules and restrictions, which can change over time, it is a good idea for the individual who names the donor-advised fund as the primary beneficiary of their retirement account to also name a charity as the contingent beneficiary of the same retirement account in anticipation that the original bequest will not be carried out as planned. If for some reason the donor-advised fund’s rules will cause problems, or the proposed charitable bequest to the donor-advised fund is actually rejected by the donor-advised fund because the decedent’s directions or restrictions cannot comply with existing fund rules and restrictions, or fund rules are incompatible with the directions that the donor places on the “advised” distributions from the separate account, naming another tax exempt public charity as a back-up beneficiary can accomplish pretty much the same tax savings objectives, albeit without input or direction from the ‘advisors’ who the decedent had identified for the primary beneficiary donor-advised fund.
- Don’t Confuse the Bequest with the Qualified Charitable IRA Distribution: It is important to keep in mind that a charitable bequest to a donor-advised fund is not the same thing as a Qualified Charitable IRA Distribution. You will recall that a qualified charitable IRA distribution is a distribution of up to $100,000 a year from a traditional IRA (not a SEP or SIMPLE IRA) by the IRA owner who is then over age 70 ½ directly to an eligible public charity that is defined in IRC 170(b)(1)(A). A qualified charitable distribution from a traditional IRA directly paid to the charity satisfies the IRA owner’s required minimum distribution (RMD) for the calendar year. [IRC 408(d)(8)] But for purposes of this special RMD rule, the public charity cannot be a donor-advised fund that is sponsored by another public charity. Accordingly, while I can name a donor-advised fund to receive my traditional IRA on my death and have that distribution qualify for the federal estate tax charitable deduction [IRC 2055], I cannot direct that lifetime transfers from my traditional IRA to the same donor-advised fund in satisfaction of my RMD for the year. Consequently the rules are different for lifetime gifts vs bequests at death to a donor-advised fund.
To summarize, retirement assets can be directed to a donor-advised fund as a charitable bequest, but a bit of preparation and study and familiarity is required ahead of time to understand the rules followed by the donor-advised fund. Certainly the donor can create the donor-advised fund while alive, but other assets, not their IRA, should be used as the ‘seed gift’ if the donor-advised fund is created during lifetime. That same donor-advised fund can then be used as the recipient for the decedent’s retirement assets on their death to fulfill their testamentary charitable giving objectives.