Qualified Retirement Plans - 401(k) and 403(b) plans, IRAs, Keoghs, and others - will be many people's major source of income after retirement. Contributions to these plans are often tax-free and usually grow tax-free as well, making these plans many peoples' largest single asset by the time they retire. Indeed, the accounts comprise around one-fourth of the assets of professionals as a group.
Yet, assets in retirement accounts are heavily taxed at death of the owner. Unlike almost any other asset, these plans must usually pay income tax, plus possible estate tax. These combined taxes can easily approach 70%. Thus, retirement plans are less valuable in the hands of heirs than they are in the hands of tax-exempt organizations like St. Anne's-Belfield School. The income and estate taxes that are saved will actually pay for most of the gift.
Mrs. Jefferson dies owning a 401(k) plan inherited from her husband. Plan assets total $600,000. An alumna, she nevertheless leaves the retirement plan to her children, while leaving the school a gift of appreciated stock, also worth $600,000.
Because of her estate's size, the plan is subject to estate tax at the 40% rate. Add the income tax, and her retirement plan could undergo taxation of up to 70%, as follows:
$600,000 Total retirement account balance
-$180,000 Income tax at 30%
-$168,000 Estate tax at 40% rate
$252,000 Remaining in retirement account after combined taxation
In this scenario, less than half of Mrs. Jefferson's retirement plan ends up where she wanted it to go—to her children.
A Better Result for Everyone
Instead of leaving the 401(k) plan to her children, Mrs. Jefferson designates the retirement plan balance for the school and gives the appreciated stock to her children. The retirement plan escapes both income and estate taxation as a charitable contribution. This arrangement also benefits her children, who inherit the $600,000 stock portfolio on these favorable terms:
- Free of taxation on any capital gain in the stock at their mother's death, since the basis in the stock is "stepped up" to its fair market value as of her death.
- Protected from any federal estate tax by the currently applicable estate tax credit.