Many of us wish to leave the majority of our assets to our loved ones, but we also want to offer some to charitable organizations. This is where some smart tax planning can really pay off.
One of the most important parts of setting up your 401(k) is naming a beneficiary. This ensures that your 401(k) can pass to someone without going through probate. However, the beneficiary will have to pay income tax on the 401(k) balance. The tax rate in this circumstance can be very steep, depending on circumstances.
There are other assets that can be passed to your heirs that are not taxed as aggressively. For example, if you pass stocks held outside of a qualified account to your heirs, your beneficiaries are not responsible for any capital gains that were achieved while you held the stock. The current price becomes their new price-point.
Leaving your 401(k) to your favorite charity and leaving the more tax-advantaged assets to your heirs makes a lot of sense. A greater percentage of your wealth will pass to where you choose, instead of to the government. Charities, since they are non-profit organizations, are tax exempt. So they pay no income tax on assets they receive.
Planning ahead now will help you avoid common mistakes.
There are three primary issues that can create significant challenges when passing on your 401(k) to a charity:
1. Imprecisely or inaccurately naming the beneficiary. Listing “Greyhound Rescue” as the beneficiary is likely to result in your money going through the probate process. Instead, you’ll want to write in something more along the lines of “Southern Florida Greyhound Rescue Society.”
- Also, be sure to list the Tax ID number for the organization. Many Tax ID numbers can be tracked down at GuideStar.
2. Possession of the account. To avoid unnecessary taxation, it is imperative that the account passes directly to the charitable organization of your choice. If your heirs or your estate were to take possession of the account and then attempt to transfer the account to the charity, your heirs would be liable for income and estate taxes.
3. Your spouse. If you wish to give your 401(k) to a charity, your spouse must sign a form agreeing to give up all rights to the account. Interestingly, this requirement is not necessary for IRAs.
Remember that you have options. Managing your estate is not necessarily all-or-nothing. You could name multiple beneficiaries and assign a percentage to each. You could also leave your 401(k) to your heirs, and your 401(k) would only pass to the charity if all the other listed beneficiaries were deceased.
Also keep in mind that the Pension Protection Act of 2006 allows IRA holders to transfer up to $100,000 to charity without paying income tax on the withdrawal. You do have to be over 70 ½ years of age to qualify, however. So using your IRA for charitable contributions is also an option.
Leaving your 401(k) to charity can be a really smart move. The tax burden on passing your 401(k) to your heirs is considerable, while charities do not have to pay income tax. Be sure to realize the total tax burden created by your choices and plan accordingly.
Estate planning is one area where the services of a professional can really pay off. Whatever you choose to do with your 401(k), good luck, and happy planning!
