The Benefits of Naming a Charity as Your IRA Beneficiary and How To Do It

If you plan to leave some of your estate to charity and you have an IRA, the smart move may be to name the charities as beneficiaries of your IRA, rather than as beneficiaries of your living trust. Why would this be a smart move?

1. Charities Don't Pay Income Tax

Note. My references in the article to your "IRA" apply to all retirement plans, such as 401ks, and will also apply to annuities.

If you name your children as beneficiaries of your IRA, they will have to pay income tax on the distributions from their inherited IRA. And under the SECURE Act, which went into effect in 2020, they must distribute the entire inherited IRA within ten years. 

If your child receives $500,000 as a beneficiary of your IRA, and she is in a 24% federal tax bracket and a 9.3% California tax bracket, she will pay $166,500 in taxes, which means she will net $333,500.

But if your charity receives $500,000 as the beneficiary of your IRA, it will receive the full amount because it is exempt from income taxes. 

If you are charitably inclined, you can leverage your charity's tax-exempt status by naming your charity as the beneficiary of your IRA.

BTW. If you are married, you will want to name your spouse as your primary beneficiary and your charity as your contingent beneficiary.

2. Keep Your Trust Administration in the Family

The goal of a trust administration is to follow the rules and distribute the assets in an efficient and timely manner. 

If your trust beneficiaries are close family members or friends, the trust administration can be done relatively quickly. But if your trust beneficiaries include charities with whom you have no relationship, the trust administration can drag to a halt.

California law entitles all beneficiaries of a trust to receive a copy of the living trust and to review and scrutinize the trust accounting as part of the trust administration. California law also allows beneficiaries 180 days to review the trust acccounting.

Almost all individual beneficiaries want to get paid as soon as possible. Same for small charities that could really use the money. However, large corporate charities can have a long and complicated process to review a trust accounting. We recently handled a trust administration where the family member beneficiaries approved the trust accounting, but the charity advised us they would require the full 180 days to review the accounting. Not because they saw any problems, but because they have so many gifts to process. As a result, even though the trustee was ready to cut checks to the beneficiaries, everything was put on hold for six months until the charity had completed its review.

Which brings us back to the point of keeping the trust administration in the family. If you named your charity as beneficiary of your IRA, you won't need to name it as a beneficiary of your trust. And if your trust beneficiaries are only close family and friends, the trust administration should go smoothly and relatively quickly.

How to Name a Charity as Beneficiary of Your IRA

The cleanest way to name a charity as beneficiary of your IRA is to name it as the only beneficiary. If you mix in your charity and individuals as your primary beneficiaries, it can make the administration more difficult for the IRA financial institution, your financial advisor, and the beneficiaires. Even worse, it could subject the individual beneficiaries to a five-year distribution window, rather than the usual ten-year window.

IRS Classifies Individuals and Charities Differently

The IRS classifies Individual beneficiaries as "designated beneficiaries" because individuals have a life expectancy. Under the Secure Act, individual IRA beneficiaries can establish an inherited IRA and they can take up to ten years to distribute their inherited IRA. This allows them to spread out the tax hit - they are only taxed when they make a distribution. However, if the decedent was taking required minimum distributions (RMDs), then the individual beneficiaries must take RMDs based on their individual life expectancy.

Unlike individual beneficiaries, the IRS classifies charities as "non-designated beneficiaries" because they do not have a life expectancy. Non-designated beneficiaries must receive their entire IRA share by September 30 of the year after the decedent's death. But if the non-designated beneficiary does not receive its share by that date, the IRS limits the distribution window for individual beneficiaries to five years, not ten years. And if the window is reduced to five years, the individual beneficiaries will have a more immediate tax hit. However, if the decedent was already taking RMDs, then instead of a five-year distribution window, the individual beneficiary must take required minimum distributions based on the decedent's life expectancy.

How Do Beneficiaries Receive Their IRA Share?

Generally, as soon as the IRA beneficiaries receive a death certificate from the successor trustee, they can contact the decedent's financial advisor, present the death certificate, and collect their share. The individual beneficiary will have two options: 1) take a lump sum and pay a tax on the entire amount, or 2) establish an inherited IRA and spread out the distributions over ten years

Example: The decedent named a charity and his two adult children as equal IRA beneficiaries. Each must coordinate with the decedent's financial advisor to claim their share, typically providing a death certificate. The charity takes a lump sum, and the children establish inherited IRAs. If the charity’s share is distributed by September 30 of the year after death, the children get ten years to distribute their shares. However, if the decedent had been taking required minimum distributions (RMDs), then the children must take RMDs based on their life expectancy. If administrative delays prevent the charity’s distribution by that date, the children’s window may drop to 5 years (if pre-RBD) or the decedent’s life expectancy (if post-RBD), increasing their tax burden.

To avoid this risk, you can split your IRA into one with charities as beneficiaries and another with individuals as beneficiaries.

Splitting Your IRA

Splitting an IRA is an administrative task, and it should not be complicated. Ask your financial advisor to create a new IRA and transfer x% of your current IRA to the new IRA. Then name your charity as the beneficiary of the new IRA.

If you intend to give 100% of your current IRA to your charity, then splitting your IRA is not necessary. But if you want to leave a portion of your IRA to your charity and the balance to your children, then you should split your IRA.

How to Name Your IRA Beneficiaries

If you are married, and especially if your IRA has been funded during your marriage, and, therefore, is community property, you should name your spouse as primary beneficiary. Then, if you want to name your charity as a beneficiary, name your charity as your contingent beneficiary. For the IRA that you don't intend to go to your charity, name your spouse as the primary beneficiary and your children, or if you have no children, other loved ones, as your contingent beneficiaries.

If you are single, a widow, or divorced, then you can name your charity as the primary beneficiary. For the IRA that you do not intend to go to charity, name your children or if you do not have children, other loved ones as your primary beneficiary.

Conclusion

If you are charitably inclined and you have an IRA, the best way to leverage your estate plan is to name your charity as the beneficiary of your IRA, rather than as a beneficiary of your trust. Your charity will receive a 100% tax-free payout from your IRA  - in contrast, your children will be taxed on their IRA payout. And, if your charity is not a beneficiary of your living trust, the trust administration can be completed more quickly and efficiently.