As people move into their seventies, a couple of things are likely to happen. They may become increasingly charitably-minded, and, if they have a traditional IRA (not a Roth IRA), they will have to begin taking required minimum distributions (RMD) from their account. Contributions to a traditional IRA are made with pre-tax dollars, which means that distributions are taxable as income. But by combining charitable impulses with distributions from an IRA, a taxpayer can both do good for a favorite charity, and reap a tax benefit at the same time. The key to this tax planning is to make a donation as a qualified charitable distribution.
Basics of Required Minimum Distributions and Charitable Donations
Historically, people who have wanted to reduce their taxable income could do so by making charitable donations, then claiming those donations as itemized deductions on their income tax return. With the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017, the standard deduction was increased and many fewer people itemized deductions on their income tax return, including taxpayers with IRAs who are obligated to take RMDs.
Individuals with a traditional IRA are required to start taking minimum distributions each year after they turn 72. As noted above, those distributions are taxable income. A taxpayer may want to use all or part of the distribution to benefit a charity, but unless they itemize deductions on their tax return, the donation will do little to reduce their income tax. (Only a small amount of charitable donations can be claimed as a deduction by those who do not itemize.)
Enter the qualified charitable distribution (QCD). A qualified charitable distribution allows the owner of an IRA to direct the custodian of the account to make a distribution directly to a qualifying charity. A QCD is not deductible from the account owner’s income; it is never counted as income in the first place. It is not reported on the IRA owner’s tax return as income and it does not pass through the account owner’s hands. IRA owners can use QCDs to stay in a lower tax bracket (if taking the distribution themselves would have bumped them into a higher bracket) and to avoid having part of their Social Security retirement benefits taxed.
The owner of an IRA can designate part or all of a distribution from their IRA to be transferred to a charity as a QCD (up to S100,000 per year). The amount can be transferred to one charity or split among multiple charities, but it must be a direct transfer from the account custodian to a qualifying 501(c)(3)charity; private foundations and donor-advised funds are not eligible to receive QCDs.
For example, let’s say that a retired taxpayer named Greg has a traditional IRA with an RMD of $10,000. Taking the entire distribution as income would bump him into a higher tax bracket. He also has a local 501(c)(3) charity he wants to support. He elects to have $8,000 transferred directly to the charity, and then takes a distribution of $2,000 to himself as income; the smaller distribution allows him to remain in his current tax bracket.
The following year, Greg decides he would like to support three charities. He has $3,000 of his RMD transferred directly to each of them by the account’s custodian, and takes a distribution of $1,000 for himself.
Greg could have taken his RMD and simply donated funds to his preferred charities after receiving it. However, the distribution would have been reported as income and Greg would have been taxed on it, leaving less for the charities and/or his own use. He could have taken a charitable deduction for the amount of the donations, but he could have deducted the full amount ONLY if he itemized deductions on his tax return.
Important Details About Qualified Charitable Distributions
For those who want to use their hard-earned retirement savings for charitable purposes and still realize a tax benefit, qualified charitable distributions are a valuable tool. However, there are several things that taxpayers should be aware of.
The timing of your QCD is very important. Using a “first dollars out” rule, the first dollars paid from an IRA during a calendar year is deemed to be the RMD. Let’s say that Greg from the example above is required to take a minimum distribution of $5,000. He takes an RMD of that amount in May of 2022. Later in the year, hoping to offset the tax on that amount, he directs his account custodian to make a QCD to a qualifying charity. Because the first dollars out of the IRA for the year were distributed to Greg, they count as the RMD. The transfer to the charity, though made directly, is not a QCD and Greg will be taxed on those funds. If Greg had the funds transferred to the charity first, then later took a distribution for himself, the charitable transfer would have been tax-free to him.
Another important fact about charitable distributions from an IRA is that they must be made within the calendar year. Unlike some contributions to retirement accounts which can be made early in one year and credited to the previous year, qualified charitable distributions are counted for the actual year in which they are made.
Charitable-minded retirees should also be aware that most QCDs are reported on Form 1099-R as a normal IRA distribution. There is generally nothing on the form to indicate that the distribution should not be taxed as income, and account custodians are not required to designate the transfer on the form as a qualified charitable deduction. It is up to the taxpayer to obtain and keep records of the QCD and inform their tax preparer that the distribution was a non-taxable QCD.
If you have questions about how to use qualified charitable deductions to your best advantage, and to the best advantage of your preferred charities, contact Estate Planning & Elder Law Services to schedule a consultation.