Posted May 1st, 2004

Planning Matters

Understanding IRAs

As most of those in the fund-raising world know, Individual Retirement Accounts have evolved since their creation in the 1970s from limited use among a handful of relatively high income Americans to one of today’s primary vehicles for building economic security in retirement years. Over the years, eligibility for tax-favored retirement plans has expanded and changed to include variations on both the traditional IRA and the newer Roth IRA so that the IRA has now become an important part of the retirement portfolios of millions of workers. Because of this fact, it is crucial for gift planners to have an adequate understanding of IRAs and the role they can play in fund development efforts.

History of IRAs

The first provisions for IRAs were created in 1974 under the Employee Retirement Income Security Act of 1974 (ERISA) as a plan limited to workers who did not have access to employment-based plans. In the early 1980s the IRA was extended to all workers under provisions of the Economic Recovery Tax Act of 1981 (ERTA).

However, after taking strides to make the IRA more accessible, Congress then restricted the tax deductibility of certain IRA contributions and created non-deductible IRAs as part of the Tax Reform Act of 1986. (Note that even though the contributions were not deductible, the funds could grow on a tax-deferred basis.)

The Taxpayer Relief Act of 1997 expanded the non-deductible IRA through the creation of the Roth IRA, under which after-tax dollars could grow on a tax-deferred basis and eventually be withdrawn tax free. Although the Roth IRA is derived from the traditional IRA, the tax treatment of withdrawals dictates that traditional IRA funds will continue to be the preferred choice for inter vivos or testamentary charitable gifts.

In good news for taxpayers, the 2001 Tax Act increased the contribution limits for IRAs. Recently, the CARE Act and other proposed legislation have included provisions to simplify and encourage the use of IRA assets for charitable purposes, but such legislation has yet to become law.

Value of retirement plans

The value of assets held in IRAs grew steadily from 1981 to 1999 before experiencing declines in 2000 and 2001 as a result of investment market declines. Initially, the growth of IRA asset value was fueled primarily by pre-tax contributions from individuals. By the late 1990s, however, most of the growth was attributable to investment returns and rollovers from various other qualified employee-sponsored retirement plans.

IRA asset value peaked at slightly over $2.5 trillion before declining to around $2.4 trillion in 2001. During that year fewer than 3.5 million individuals out of the more than 130 million federal income tax returns for 2001 reported receiving IRA payments. (See page 4 for additional information.)

Of the 3,448,457 individuals in 2001 reporting IRA payments, 836,593 had an adjusted gross income (AGI) of under $30,000. Another 895,335 persons had an AGI in the $30,000 to $49,999 range, and 1,114,172 fell into the $50,000 to $99,999 range. In the highest income group, 496,167 returns revealed an AGI in the $100,000 to $200,000 range. Just 106,189 returns fell in the over $200,000 category.

Implications for gift planners

With the possible passage of legislation to encourage charitable gifts from IRAs still looming on the horizon, gift planners need to be aware of both current and potential IRA gift opportunities. To do so it is critical to understand the makeup of the IRA market. For upper, middle, and upper lower income IRA holders who itemize, IRA assets may represent a convenient source for making charitable gifts while con-serving non-IRA cash balances. Although the amount withdrawn will be reported as income on tax returns, there will be a corresponding charitable deduction for the same amount as an itemized deduction. For those over 5912 who are not subject to a penalty for early withdrawal, the result will generally be a wash for tax purposes.

Some high-income taxpayers who fund gifts with IRA assets may find that they must make slight down-ward adjustments to their itemized deductions. These gifts will generally be deductible up to 50% of their AGI. To avoid being taxed on donated amounts, care should be taken not to exceed that limit, even though the excess deduction may be carried over for use in future years.

Estate gifts enjoy unlimited charitable deductions. Because any non-charitable heirs would have to pay taxes on traditional IRA distributions, those who wish to make a charitable gift from their estates may choose to give from IRA funds while leaving other assets that are taxed more favorably to family and other loved ones.

If the CARE Act is eventually passed, it will be important to understand the limitations of any new law in order to take full advantage of its provisions. Keep these factors in mind:

  • All current proposals deal only with IRA accounts, not 401(k)s, 403(b)s, or other plans.
  • There are likely to be age restrictions for outright or planned gift arrangements. The bill passed by the Senate calls for a minimum age of 70 for out-right gifts and a minimum age of 5912 for other arrangements like charitable remainder annuity trusts, charitable remainder unitrusts, and gift annuities. The House bill provides for an age limit of 7012 for both outright and deferred gifts funded from IRA assets.
  • There will be no additional income tax deductions. Transactions will simply be a wash for tax purposes.
  • All payments from life income gifts funded with IRA assets will be taxed as ordinary income taxed at the highest applicable rate. There will be no tax-free return of principal or lower tax rates for distributions of capital gains or dividends.
  • Proposed life income gifts may qualify only for the donor and spouse, not for third parties.

Given these limitations, perhaps the greatest benefit for the nation’s nonprofits will result from simplifying rules and encouraging charitably motivated persons to consider these assets as an additional source for funding outright gifts in retirement years.

If you would like more information about how pro-posed federal tax legislation may affect gifts of retirement plan assets, visit www.ncpg.org. See page 3 for upcoming training opportunities that feature the use of retirement plan assets in charitable planning, or visit www.sharpenet.com/seminars.

The publisher of Give & Take is not engaged in rendering legal or tax advisory service. For advice and assistance in specific cases, the services of your own counsel should be obtained. Articles in Give & Take may generally be reprinted for distribution to board members and staff of nonprofit institutions and other non-donor groups. Proper credit must be given. Call for details.

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