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Tax-Conscious Bequests

Doug Koenig,

October 05, 2017

Growing Your Wealth, Managing Your Money


The advent of a higher amount exempt from the federal estate tax ($5.49 million in 2017) has reduced the need for tax-aware estate planning, but it has not eliminated it altogether. Estates of any size will be subject to income taxes, as will their beneficiaries. Planning may permit this burden to be reduced.

Take charitable bequests, for example. Past practice generally has been to provide for charity from the principal of an estate, according to law professor Christopher Hoyt [“Tax Savings with Income-Based Charitable Bequests, Probate & Property, September/October 2017]. The better approach from a tax perspective would be to direct the executor to make a payment to charity from the estate’s income. Instead of a will clause providing $50,000 to a selected charity, the will could direct the first $50,000 of income collected by the estate to be used for that purpose. That would garner an income tax deduction for the estate, leaving more money for the other heirs.

Income in Respect of a Decedent

Most assets acquired from an estate receive a basis step-up to their fair market value at death. With a basis step-up, there will be little or no tax due upon the capital gain if the asset is sold soon. Some assets do not receive any basis step-up, however, such as Series EE savings bonds and employee stock options. Because these would have been subject to income tax in the hands of the decedent, they are “income in respect of a decedent” (IRD) and remain subject to the income tax, as well as the estate tax. The most prevalent source of IRD is an interest in an inherited retirement plan account.

One approach to limiting the income tax exposure with IRD is to use it to fund charitable bequests. The IRD may be paid directly to a charity, so that it never will need to be recognized by the estate. If the IRD will be distributed to the estate, the will should instruct the executor to pay charitable bequests to the extent possible from the IRD, which will generate an offsetting charitable deduction.

With retirement accounts, the beneficiary designation form is key, as the assets may pass outside of probate. A charity may be named as the beneficiary of some or all of the retirement account. To the extent that assets pass directly to the charity, the estate will not have to recognize IRD.

What about a forgotten retirement account for which no beneficiary was named? The asset will pass to the probate estate by default. It may be possible for the executor simply to distribute the retirement account directly to a charity. Alternatively, instructions to the executor to pay charitable bequests from IRD when it is available may cure the tax problem.

Charitable Giving Grows

According to the annual report of Giving USA, total charitable gifts rose by 2.7% in 2016, reaching $390.05 billion. Giving by individuals was up 3.9%, by foundations 3.5%, and by corporations 3.5%.

Charitable bequests were estimated to have declined by 9.0%, perhaps attributable to the elimination of federal estate taxes for the vast majority of estates. However, bequests only account for 8% of all contributions, while individuals provide 72% of the total charitable support.

Total charitable giving was roughly 1.7% of the country’s gross domestic product through the 1980s. By this measure, giving grew in the 1990s, reaching 2.2% of GDP in 2001. It fell to 1.9% of GDP during the great recession, but has since climbed back to 2.1% of GDP.

© 2017 M.A. Co. All rights reserved

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This blog article is for informational purposes only, and is not an advertisement for a product or service. The accuracy and completeness is not guaranteed and does not constitute legal or tax advice. Please consult with your own tax, legal, and financial advisors.

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