How to Use IRA Distributions for Tax Efficient Charitable Planning
Key Points:
The Tax Cuts and Jobs Act eliminated the benefit of itemized deductions for many, but there are still strategies that may provide some additional tax savings.
Using a Qualified Charitable Distribution (QCD) from an IRA can provide tax benefits that otherwise might be lost for some taxpayers.
There are many rules surrounding the use of a QCD, and careful planning is required to meet these requirements.
In many ways, the Tax Cuts and Jobs Act (TCJA), passed in December 2017, marked the beginning of a new approach to tax planning. There are new tax rates, new terms, and new forms to file. It is no wonder that some may just want to bury their head in the sand and hope that their tax return gets filed correctly! But while there are many changes, there are also many opportunities that should not be overlooked when it comes to tax planning.
Some of the changes under the TCJA were to reduce state income and property tax deductions and to eliminate the deduction for most investment expenses, while substantially increasing the standard deduction. These changes may be problematic for many individuals that have the desire to support their favorite organizations each year through charitable donations, as these charitable donations may no longer receive a tax benefit through the use of itemized deductions.
So what tax benefits are still available when it comes to making your annual gifts? For those charitably inclined individuals that are age 70.5 or older, an important planning opportunity is the use of the Qualified Charitable Distribution (QCD). While the QCD has been around for some time, the benefit of using this strategy has become more attractive with the TCJA’s changes to itemized deductions.
What is a Qualified Charitable Distribution?
Generally, a QCD is an otherwise taxable distribution from an IRA account owned by an individual who is age 70.5 or over that is paid directly from the IRA to a qualified charity. The rules regarding the qualification of these distributions are very specific, but with careful planning and execution, the benefits can be substantial.
Under the QCD requirements, the owner of the IRA must be 70.5 at the time of the charitable distribution. In addition, the distribution must go directly to a public charity, and cannot be used with a private foundation or a donor-advised fund (DAF). The distribution must not result in any benefit to the donor (other than the tax benefit), so it cannot be used for things such as event tickets, memberships or other privileges. Finally, the maximum amount of a QCD for any individual from his or her IRA(s) is limited each year to $100,000.
So, why is the availability of QCDs so impactful? To answer this, we should first consider the tax issues related to Required Minimum Distributions (RMDs).
Tax Issues Related to Required Minimum Distributions
For individuals who have IRA account balances (other than Roth IRAs), an RMD must be taken out of the account each year, beginning in the year that the account owner turns 70.5. Generally speaking, the RMD is calculated based on the IRA account balance each year and the age of the account owner.
This RMD is subject to ordinary income tax each year. If an individual has significant value in their retirement accounts, this RMD amount can be substantial, pushing the individual into a higher tax bracket and eliminating other tax benefits. However, if the RMD is used in-whole or in-part as a QCD, the part of the RMD that qualifies as a QCD will escape taxation and reduce the individual’s adjusted gross income for the year.
Maximizing Your Donation Benefits
When evaluating the savings of a QCD, the benefits may go even further than just the removal of the RMD from taxation. By lowering an individual’s adjusted gross income, there may be other benefits received, such as a lower threshold for the medical expense deduction, lower state income taxes, or even a reduced portion of Social Security income being subject to tax. In addition, the lower taxable income may prevent a possible increase in Medicare premiums.
It should be noted that if a distribution qualifies as a QCD, no charitable itemized deduction will be allowed for that amount. However, the tax benefits received from the elimination of the ordinary income will usually outweigh the removal of the deduction.
Because tax planning is never simple, when evaluating the benefit of using a QCD, thought should also be given to the availability of using appreciated securities (in non-IRA accounts) for an annual gift. If an individual can itemize their deductions, donating appreciated securities can be another tax savings that should be weighed against the use of the QCD.
Other Issues to Consider
Retirement accounts do come in several different forms, and this is important as not all of them will qualify for the QCD treatment. Both a traditional and inherited IRA can be used for QCDs as long as the owner/beneficiary is 70.5 at the date of distribution. A SEP or SIMPLE IRA, however, cannot be used with the QCD strategy if they are still active (meaning there are still ongoing contributions to the SEP or SIMPLE IRA). And while a Roth IRA can be used, the benefit of the QCD is most often lost, as Roth distributions are generally not subject to income tax.
It should also be noted that the $100,000 limit each year for the QCD is determined on a per-person basis across all IRA accounts. Therefore, a married couple would each be able to use the QCD up to the $100,000 maximum (for a total of $200,000) if the distributions came from each of their respective IRAs.
Finally, the tax reporting of the QCD requires good communication with your tax preparer. The QCD out of the IRA will still be reported on a Form 1099-R as a normal distribution. If the tax preparer is not aware of the QCD, they may continue to treat the distribution as fully taxable as an RMD, rather than making the correct notation on the tax return and removing the distribution from income.
Conclusion
Charitable giving is not always about the tax benefits received. But if there is intent to give, careful planning on how a donation is made can be very impactful on an individual’s tax liability. Even after the recent tax code changes, there are many tax planning opportunities with charitable gifts —a Qualified Charitable Distribution is one of those opportunities.
Sources:
IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)
IRC Sec. 408(d)(8)