The federal estate tax is a transfer tax that applies if your estate exceeds the federal exclusion amount. The federal exclusion amount is $2,000,000 for 2006-2008.  The amount increases to $3,500,00 in 2009 and the federal estate tax is eliminated in 2010.  The Tax Act of 2001, however, contains sunset provisions which reinstates the tax for estates over $1,000,000 in 2011.

Generally, bequests are not subject to income tax even though they may be subject to estate tax. The exceptions to this are deferred tax plans, such as traditional IRAs, 401(k) and 403(b) plans, Keoghs, etc., which are funded with pre-tax dollars and earn interest tax-free. Funds that are withdrawn from such plans are subject to federal and state income tax at the time of withdrawal, regardless of whether the funds are withdrawn during your lifetime or after your death. As a result, these deferred tax plans are potentially subject to both estate tax and income tax.

There are two ways that gifts to a qualified charity can reduce taxes at your death. First, gifts to qualified charities can generally qualify for a deduction from the federal estate tax. Second, gifts to qualified charities can also eliminate income tax liability for a deferred tax plan.

Let's look at how a charitable gift can be best structured to accomplish your charitable goal and provide your family with the most beneficial tax treatment:  Worse Result: Your will (or trust) provides for a $75,000 gift to a qualified charity when you die. At the time of your death, your estate is worth $750,000 and you have a 401(k) plan worth $70,000. The 401(k) plan designates your two children as beneficiaries. Your personal representative or trustee distributes $75,000 in cash from your estate to the designated charity.  However, when your children receive the $70,000 proceeds from the 401(k), they must pay income tax on the proceeds. Assuming they are in a 28% tax bracket, the income tax on the 401(k) would be $19,600, leaving only $50,400 for your children.

Better Result: Instead of designating your children as the beneficiaries of your $70,000 401(k) plan, you designate the charity as the beneficiary. At your death, your personal representative or trustee distributes the 401(k) plan, plus an additional $5,000 in cash (to make up the total $75,000 gift) to the charity. You still get the $75,000 deduction from the federal estate tax and avoid the income tax liability on the 401(k) plan. The full $70,000 in the 401(k) goes to the charity, and you have eliminated the $19,600 income tax liability. There is more money left to distribute to your family.

Careful planning can help you accomplish two important goals: benefiting a worthy charity of your choice and doing so in such a way as to provide the very best tax result for your family. Because everyone's tax situation is different, you should talk to your own tax counselor or estate planning attorney to determine what is best for you.

This summary is intended as a source of general information.  If you have questions or desire additional information, please contact Ryan M. Wilson at (517) 377-0897 or rwilson@fraserlawfirm.com.