Link to this article in the Tri-Cities Journal of Business.

It is no secret that Americans are a very generous people. In 2022, Americans donated $319.04 billion to charities with an additional $45.6 billion given by those who listed charities in their wills or as beneficiaries on their retirement accounts. Today, I want to focus on the latter group, those who give after their passing.

Charitable giving can be an important part of building your legacy. However, if you intend to leave behind assets for both family members and a charity, there are some assets that are more beneficial to gift to family members compared to a charity, at least from a tax perspective. Let’s look at an example.

Barbara is a widow and nearing the end of her life and wants to review her estate plan. She has a net worth of $1.2 million comprised of the following assets:

IRA worth $200,000
Home worth $500,000
Brokerage account worth $500,000

For Barbara’s IRA, she has listed her son as the beneficiary, meaning he will receive the entire $200,000. However, her will, which controls her home and brokerage account, has 90% of her non-retirement fund assets going to her son, with the remaining 10% being donated to the St. Francis Animal Shelter. From the will, we have $900,000 going to Barbara’s son and $100,000 going towards the Animal Shelter. In total, $1.1 million will be going to Barbara’s son with $100,000 allocated towards St. Francis Animal Shelter.

While the dollar amounts in this example might be unique, reflecting Barbara’s generous and saintly care for all God’s creatures, the listing of charities in someone’s will is a common occurrence. Despite good intentions, this is an inefficient plan from a tax standpoint. If we add a little more detail to the scenario, we can say Barbara’s house has a cost basis of $300,000 and the brokerage account has a cost basis of $100,000. This means that during her lifetime, Barbara has unrealized capital gains of $400,000. All the unrealized gains are from her brokerage account since her home is under the $250,000 exclusion amount for personal residences.

Once Barbara passes away, her home and brokerage account will receive what is called a step up in cost basis. This raises the cost basis of those assets to their market value on the date of Barbara’s death. To keep things simple, we’ll say nothing exciting happened in the economy, and all Barbara’s assets have the same value on the date of her death. This means when Barbara’s son sells Barbara’s home, he will likely pay little to no capital gains taxes on that $500,000. He will also pay little to no capital gains taxes on the sale of the inherited stocks or mutual fund holdings. St. Francis Animal Shelter also won’t have to pay any capital gains taxes, but that is because they are a charity. Instead, they just have to wait until the end of the probate process before they can receive the $100,000 allocated to the animal shelter.

The IRA is a different story though. Barbara’s son receives $200,000 from the IRA, but since the IRA is tax-deferred, the government still wants to collect taxes on future distributions. Her son will then need to navigate the ten-year rule for beneficiary IRA distributions with those distributions being taxed to him as ordinary income. More money, even when it is taxed, is generally better than no money, but there is still a more tax-efficient way to distribute funds between Barbara’s beneficiaries.

We’ll keep the dollar amount of all the assets the same, but instead of naming St. Francis Animal Shelter as a 10% beneficiary in her will, Barbara has her son inherit all the assets governed by her will, which totals $1 million. Then she names the Animal Shelter as a 50% beneficiary of her IRA with her son receiving the other 50%, meaning they each receive $100,000. In this scenario, Barbara’s son is still allocated $1.1 million in total with the Animal Shelter receiving $100,000, but we have reduced her son’s future tax liability.

Barbara’s son receives the entire benefit of the step up in cost basis for Barbara’s home and brokerage account while reducing his tax liability by inheriting a smaller percentage of the IRA, though the total dollar amount of his inheritance of Barbara’s assets remains the same. St. Francis Animal Shelter still doesn’t pay taxes on the $100,000 they receive, but the IRA skips the probate process. This means the Animal Shelter receives their funds faster, allowing them to quickly deploy funds to assist the vulnerable population they serve. Even more importantly, Barbara has shifted $100,000 of the taxable portion of her estate to an entity that doesn’t have to pay taxes and, if her son is in the 22% tax bracket, she just saved him $22,000 in taxes (even more if he happens to be in a higher tax bracket).

Charitable giving can be an important part of leaving a legacy. When crafting your charitable vision, it is important to remember that assets are treated differently from a tax perspective by their recipients. A well-defined estate plan that takes charitable giving into account will get those assets to charities in the quickest way possible and reduce the tax liability for those beneficiaries who don’t have a 501(c)(3) status.