In the course of helping clients navigate the many roads that lead to their financial and personal goals, we will at some point reach the intersection of charitable planning and 401(k) plan assets. While 401(k)s have much in common with the broader group of qualified retirement accounts like IRAs, there are also differences worth knowing since they may impact the advice you provide.
There are several reasons a client may choose a 401(k) over other retirement saving vehicles, if they have access to one:
- Annual contribution limits are higher than IRAs ($19,500 versus $26,000 in 2021).
- A client’s employer may match contributions.
- A client who is still working at age 72 (or age 70 ½ if born before July 1, 1949) can defer starting Required Minimum Distributions (RMDs) until they stop working (unless they are a 5% or greater owner).
Whichever the case, the client’s 401(k) will likely represent a significant part of his or her estate, and it can play a major role in the client’s charitable planning.
For income tax purposes, a 401(k) is considered Income in Respect of a Decedent (IRD), meaning that it remains a pre-tax asset after a client passes away. Whereas investments outside of a qualified retirement plan get a step-up in basis upon death which eliminates unrealized capital gain, 401(k) assets are still taxable after death at ordinary income tax rates when withdrawn. Therefore, maximizing a client’s charitable bequest at death with 401(k) assets will yield significant income tax savings.
For example, consider a client who is a widow with one child, and who desires to leave her estate 50% to the child and 50% to a donor-advised fund (DAF), which will allow the child to carry on her legacy of charitable giving. Her estate is valued at $3,000,000, which includes a 401(k) worth $500,000 and the remainder held in her revocable trust. If she were to name her DAF and the child each as a 50% beneficiary of her 401(k), and her trust distributes 50% to each, the result would be as follows (assume the child is in the 35% federal income tax bracket):
Now, assume you advise your client to name the DAF as beneficiary of 100% of the 401(k), and have her trust allocate an amount equal to 50% of her total estate (i.e., inclusive of her 401(k)) to here child and the remainder to the DAF:
The passage of the SECURE Act in 2019 has made naming a charitable beneficiary even more favorable than pre-SECURE Act. The SECURE Act eliminated the ability for most beneficiaries of inherited 401(k)s to defer income taxes over the course of their lifetimes. Unless a beneficiary is an “eligible designated beneficiary” (a spouse, a child under the age of majority, a disabled or chronically ill individual, or an individual less than 10 years younger than the account owner), the beneficiary must fully deplete the account within 10 years and recognize the income. This means that the income taxes can no longer be spread out over the life expectancy of the beneficiary, which may result in more income tax paid on the inherited 401(k).
If a client wishes to name a charitable beneficiary for their 401(k), they should first check with their plan administrator to make sure the 401(k) plan allows it. Unlike IRAs, some 401(k)s may limit who is a permissible beneficiary. It is a best practice to contact the charitable organization’s administrator for the entity’s full legal name and Tax Identification Number for the beneficiary designation form. Also, unlike IRAs, a 401(k) requires a client’s spouse to consent to naming anyone other than the spouse as a beneficiary, so the applicable spousal waiver will need to be obtained and properly executed.
If the plan sponsor does not allow for a charitable beneficiary to be named, the client should plan to execute a tax-free rollover of the 401(k) account to an IRA when it makes economic sense so that he or she can have full control over naming the beneficiary.
However, if a client is married, you should check first if the client’s spouse is 10-plus years younger than the client. If so, keeping the spouse as the primary beneficiary will allow the client to reduce their RMD, since they can use the more favorable joint life expectancy table to figure the RMD amount, thus lowering their income tax liability annually.
A workaround in this case is to keep the spouse as the primary beneficiary, name the charity as the secondary beneficiary, and have the spouse agree to disclaim their interest in the 401(k) should this be necessary. In such cases, a DAF works well, since the surviving spouse retains the ability to direct those charitable assets over their lifetime to fulfill their lifetime giving goals, while still receiving the immediate full income tax and estate tax benefits.
Another difference with 401(k)s is that the plan account can’t be divided into multiple accounts for different beneficiaries, as can be done with IRAs. If a client wishes to leave only a part of a large 401(k) to charity, the division has to be done on the beneficiary designation form. If this becomes necessary, it is important to note that, after death, the charity’s portion of the 401(k) must be fully paid out by September 30 of the year following death, or else the non-charitable beneficiaries will lose the ability to stretch out their distributions over their lifetime if they are eligible designated beneficiaries as defined by the SECURE Act.
Retirement plan assets like a 401(k) can be leveraged significantly to fulfill a client’s charitable giving goals. Initial contributions reduce taxable income, earnings are tax-free, and distributions to a charity are tax-free while also providing a deduction for estate tax purposes. Every conversation with a client about planned charitable giving should consider how to deploy these assets if possible. It will fulfill the common goal of maximizing the benefit to the charitable organization, while accruing tax savings to the client’s family.
This article was originally published by American Endowment Foundation, https://www.aefonline.org. Dawn Jinsky is a CPA, CFP, and a partner in Plante Moran’s Wealth Management group. She leads the firm’s wealth transfer practice, which includes both the estate and business transition practice. With more than 20 years in wealth management, she specializes in estate planning, wealth transfer, charitable planning, and assists family business owners with their transition plans. Dawn is a member of AEF’s Council of Advisors.