IRA Charitable Endowment Plan Case Study
Estate Plan Concerns
Bill (age 72) is the owner of a qualified Individual Retirement Account (IRA), which currently has a balance of $1,000,000. He and his wife, Mary (age 70), enjoy a comfortable standard of living, which is easily provided for by Bill's IRA and their other financial assets. In fact, they don't really need the entire IRA, and Bill is currently taking distributions from the IRA only because the tax law specifies required minimum distributions at his age.
► Donating IRA to Charity Would Eliminate Estate and Income Taxes
Over the years, Bill and Mary have enjoyed contributing to various charities, and they recently have been discussing the possibility of a gift that would provide a large endowment for their favorite charity after their deaths. Bill has recently learned that his IRA will be subject to both estate tax and income tax after his and Mary's deaths, and he has considered passing the IRA to their favorite charity to eliminate both taxes.
Estate Plan Solution
After careful consideration, Bill and Mary decide to use a planning technique known as the IRA Charitable Endowment Plan. The technique will allow Bill and Mary to create a large endowment for their favorite charity after their death's using life insurance, with premiums funded by tax-free gifts from Bill's IRA to the charity.
IRA Charitable Endowment Plan Process
- Bill and Mary choose Favorite Charity as the beneficiary of their IRA Charitable Endowment Plan, which will be funded with an annual premium of $100,000 for only 2 years. Favorite Charity is qualifying public charity under Section 170 of the Federal Internal Revenue Code.
- Favorite Charity is the applicant, owner and beneficiary of a survivorship life insurance policy, insuring Bill's and Mary's lives in the amount of $720,000 (death benefit payable on the survivor's death).
- Bill instructs the trustee of his IRA make an income tax free transfer of $100,000 directly to Favorite Charity before the end of 2006. In 2007, the trustee of the IRA will transfer another $100,000 to Favorite Charity.
- Favorite Charity uses the funds received from Bill's IRA trustee to pay the annual premium on the survivorship policy insuring Bill's and Mary's lives. In 2007, Favorite Charity will use the funds received from the IRA trustee in that year to pay the second and final life insurance premium.
- At the death of the survivor of Bill and Mary, Insurance Company pays an income tax free and estate tax free death benefit of $720,000 to Favorite Charity, providing Favorite Charity an endowment in accordance with Bill's and Mary's wishes.
- The remaining balance of Bill's IRA could be passed to their family, but would be subject to both estate and income taxes. Alternatively, the remaining balance could be passed to Favorite Charity (or another charity) free of estate and income taxes.
- Charity Acquires Life Insurance on Donor: Tax-free dollars from the IRA are used by the charity to acquire life insurance on the donor, multiplying the benefit of the gift and creating a generous endowment.
- No Tax on IRA: Donor (IRA owner) avoids income tax on qualified charitable distributions from the IRA.
- New Rules Apply: New special rules allow donor to avoid complicated charitable deduction rules that otherwise could have resulted in taxation of the IRA distribution.
- Fulfills Distribution Requirement: Charitable distribution counts toward required distribution for the IRA owner.
- Easy: Simple to implement.
This hypothetical case study illustrates the commonly used technique of creating a large endowment for charity through life insurance. Generally, the life insurance is funded through lifetime cash gifts from the insurance policy, uses the cash gifts to fund premium payments. Upon the death of the insured donor, the charity receives the policy proceeds completely free of income tax and estate tax. The donor's cash gifts are, generally, deductible for federal income tax purposes by the donor, but the gifts are subject to rules that may limit the charitable deduction based on the type of gift, the type of charitable organization and the donor's adjusted gross income. The charitable deduction can also be reduced through the provision of the tax law that reduces itemized deductions for certain high income taxpayers.
► Donations Equal Annual IRA Distributions
The donor's Individual Retirement Account (IRA) is commonly used as a source of the donor's cash gifts (for donors over age 59½). The donor takes a distribution from his or her IRA, which is includible in gross income for federal income tax purposes. The donor then makes a cash gift to the charity equal to the IRA distribution. If the gift to charity is fully deductible for federal income tax purposes, then the taxable IRA distribution is completely offset by the charitable deduction, resulting in no income tax being levied on the IRA distribution. Consequently, the policy premium would be funded on an income tax free basis. However, applying the various complex rules that govern deductibility of charitable contributions (as mentioned above), the donor's income tax deduction may be reduced, causing a portion or possibly all of the IRA distribution to be subject to income tax. Fortunately, a little time doing some advance planning usually can resolve these issues.
► Special Rules for 2006-2007
In 2006, federal tax legislation was enacted that allows an IRA owner who is at least age 70½ to arrange for income tax free distributions directly form the IRA trustee to a qualifying charity. This new law, which is available for taxpayers only during taxable years 2006 and 2007, provides a simple and effective way to eliminate the potential problem of exposing the IRA distribution to income tax due to a reduced charitable deduction.
Generally, the new law (IRC §408(d)(8) added b the Pension Protection Act of 2006) allows a taxpayer to exclude from gross income the amount of "qualified charitable distributions" during a taxable year up to a maximum of $100,000. However, this exclusion is available only for qualified charitable distributions made in taxable years 2006 and 2007. To qualify as a qualified charitable distribution: the taxpayer must be at least age 70½; the distribution must be made directly from the trustee of the IRA to the charity; the charity must qualify as a public charity under IRC §170(b)(1)(A); the charity must not be supporting organization or a donor advised fund; and the IRA distribution, without the new law, would have been includible in gross income. Note that this special provision would be available for both husband and wife for their respective IRA's, even if they were to file a joint return. Thus, assuming that each spouse satisfied the requirements as to their respective IRA's, it would be possible for a married couple to make qualified charitable distributions up on an overall maximum of $200,000 in a given taxable (i.e., $100,000 for each spouse).
► Insurance Policy Assumptions
The potential scenario illustrated in this case study makes the following assumptions concerning the life insurance product: use of a survivorship universal life insurance policy (death benefit payable at the surviving insured's death); face amount of $720,000; insuring 2 hypothetical individuals, a male, age 72 and a female, age 70 (both with standard non-smoker ratings); and an annual premium of $100,000 is paid for only 2 policy years, which is sufficient to provide a guaranteed death benefit of $720,000. Any policy that is issued to an actual applicant for insurance will depend on the insured's specific situation and the results of underwriting.
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The following notice is required by the IRS: Any U.S. Federal tax advice contained in this communication is not intended to be written or used, and cannot be used or relied upon, to avoid tax-related penalties under the Internal Revenue Code, or to promote, market or recommend to another any tax-related matter addressed herein.
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