When developing your estate plan, you can do well by doing good—leaving money to charity rewards you in many ways. It gives you a sense of personal satisfaction, and it can save you money in estate taxes.
A few words about transfer taxes
The federal government taxes transfers of wealth you make to others, both during your life and at your death. In 2020 the federal gift and estate tax is imposed on transfers over $11,580,000 and at a top rate of 40%. A separate generation-skipping transfer (GST) tax is imposed on transfers made to grandchildren and lower generations. For 2021, there is an $11,700,000 exemption, and the top rate is 40%. You may also be subject to state transfer taxes.
Careful planning is needed to minimize transfer taxes, and charitable giving can play an essential role in your estate plan. By leaving money to charity, the full amount of your charitable gift may be deducted from the value of your gift or taxable estate.
Make an outright bequest in your will
The easiest and most direct way to make a charitable gift is by an outright bequest of cash in your will. Making an outright bequest requires only a short paragraph in your will that names the charitable beneficiary and states the amount of your gift. The outright bequest is especially appropriate when the amount of your gift is relatively small or when you want the funds to go to the charity without strings attached.
Make a charity the beneficiary of an IRA or retirement plan
If you have funds in an IRA or employer-sponsored retirement plan, you can name your favorite charity as a beneficiary. Naming a charity as a beneficiary can provide double tax savings. First, the charitable gift will be deductible for estate tax purposes. Second, the charity will not have to pay any income tax on the funds it receives. This double benefit can save combined taxes that otherwise could eat up a substantial portion of your retirement account.
Use a charitable trust
Another way for you to make charitable gifts is to create a charitable trust. There are many charitable trusts, the most common of which include the charitable lead trust and the charitable remainder trust.
A charitable lead trust pays income to your chosen charity for a certain period of years after your death. Once that period is up, the trust principal passes to your family members or other heirs. The trust is known as a charitable lead trust because the charity gets the first, or lead, interest.
A charitable remainder trust is the mirror image of the charitable lead trust. Trust income is payable to your family members or other heirs for years after your death or for the lifetime of one or more beneficiaries. Then, the principal goes to your favorite charity. The trust is known as a charitable remainder trust because the charity gets the remainder interest. Depending on which type of trust you use, the dollar value of the lead (income) interest or the remainder interest produces the estate tax charitable deduction.
Why use a charitable lead trust?
The charitable lead trust is an excellent estate planning vehicle if you are optimistic about the future performance of the trust investments. If created properly, a charitable lead trust allows you to keep an asset in the family while being a useful tax-minimization device.
For example, you create a $1 million charitable lead trust. The trust provides for fixed annual payments of $80,000 (or 8 percent of the initial $1 million value of the trust) to ABC Charity for 25 years. At the end of the 25 years, the entire trust principal goes outright to your beneficiaries. To figure the amount of the charitable deduction, you must value the 25-year income interest going to ABC Charity. To do this, you use IRS tables. Based on these tables, the value of the income interest can be high–for example, $900,000. This means that your estate gets a $900,000 charitable deduction when you die, and only $100,000 of the $1 million gift is subject to estate tax.
Why use a charitable remainder trust?
A charitable remainder trust takes advantage of the fact that lifetime charitable giving generally results in tax savings compared to testamentary charitable giving. A donation to a charitable remainder trust has the same estate tax effect as a bequest because, at your death, the donated asset has been removed from your estate. However, be aware that a portion of the donation is brought back into your estate through the charitable income tax deduction.
A charitable remainder trust can be beneficial because it provides your family members with a stream of current income–a desirable feature if your family members don’t have enough income from other sources.
For example, you create a $1 million charitable remainder trust. The trust provides that a fixed annual payment be paid to your beneficiaries for a period not to exceed 20 years. At the end of that period, the entire trust principal goes outright to ABC Charity. To figure the amount of the charitable deduction, you have to value the remainder interest going to ABC Charity, using IRS tables. This is a complicated numbers game. Trial computations are needed to see what combination of the annual payment amount and the duration of annual payments will produce the desired charitable deduction and income stream for the family.
Every person’s financial situation is different. Therefore, it is crucial to work with a financial planner to determine the best way to give to charity. Your situation is unique and therefore requires a specialized solution. The right financial planner will keep your goals in mind and help you navigate charitable giving’s complicated tax implications.