Why Making A Charitable Distribution Directly From An IRA Can Be Tax Smart!
By Harry Harelik CPA, CFRE
While the option of making a charitable distribution from an IRA is only available to those taxpayers over 70½ years of age, the option is an important one to keep in mind for all taxpayers because it may be important to older taxpayers and to those whose parents or grandparents are still living and may need help in the decision making. Before understanding the reason the option may be a good one, we need to understand the limitations involved.
The distribution potential of an IRA is one that has been put into permanent tax law. Any taxpayer over 70½ when the distribution is made may gift directly from his or her IRA into a nonprofit (not including a donor advised fund or a type III supporting organization) up to $100,000 in each calendar year. It is important that taxpayers understand that one does not have to make a transfer of $100,000 as it can be any amount… even $1,000 or less. Further, the transfer does not have to be made just to one qualifying nonprofit; it can be made to any number as long as the grand total doesn't exceed $100,000 per year per taxpayer. The transfer does have to be directly to the nonprofit. It can't be received by the taxpayer and then paid to the charity. The example at the end of this discussion demonstrates why a direct IRA distribution to charity, avoiding income and deduction reporting, can be tax wise.
Without this special provision, a gift to charity that would be funded from an IRA distribution, would be included in taxable income and a potential deduction would then be claimed on the itemized deduction schedule. There are three potential issues with this process: (1) by including the amount in taxable income, the taxpayer's adjusted gross income, appearing in the last line of page 1 of the tax return, will be increased and this can reduce potential other deductions and credits as discussed below, (2) some taxpayers don't itemize deductions and, then the taxpayer is reporting income against which he has no additional deduction, which increases the income tax he will pay and (3) if the taxpayer's donations exceed the current year's limit, taxpayers generally cannot currently deduct (but must carryover) charitable contributions exceeding 50% of the taxpayer's adjusted gross income.
Below are income tax deductions and credits which can be reduced as the adjusted gross income (AGI) or modified adjusted gross income ( MAGI) increases:
- Deductions: Both the medical expense and miscellaneous expense deductions are reduced as income increases. Medical expenses are only deductible to the extent they exceed 10 of % AGI (7 ½% for taxpayers 65 or over) and miscellaneous itemized deductions are only deductible to the extent they exceed 2% of AGI.
- Credits: The following income tax credits are reduced or eliminated as AGI or MAGI increases: Earned Income Credit, Child Dependent Care Credit, Adoption Credit, Savings Credit, Small Business Health Care Credit, Plug-in Electric Vehicle Credit, Manufacturer's Energy Efficient Appliance Credit or Research Credit. Older taxpayers who adopt or have grandchildren in their household may qualify for some of these credits as will those who are active in a proprietorship or partnership.
Other: Items that could be adversely affected by including an IRA distribution in Income, thereby increasing AGI or MAGI:
- As income increases, more social security income becomes taxable
Future medicare premiums and prescription drug coverage premiums will be increased as income increases:
- If single and MAGI exceeds $85,000 or if married and MAGI exceeds $170,000, premiums are $736.80 more per year
- Premiums continue to increase at various income levels until, ultimately, if single and MAGI exceeds $214,000 or if married and MAGI exceeds $428,000, premiums are $4090.80 more per year
- If a taxpayer is filing one or more state income tax returns, either as a resident, non-resident or part year resident, increased income from an IRA distribution may also cause increases in state income taxes (and city taxes, if applicable, as well).
- The alternative minimum tax can be affected by the income reported on the income tax return particularly if claiming itemized deductions
- If, in an estate situation, more non retirement dollars are left to heirs in the IRA assets and less is left to heirs in non-IRA accounts, beneficiaries then will have potentially more income tax liability because assets flowing to a beneficiary of an estate are not income taxable to the beneficiary but funds flowing from an IRA to a beneficiary ARE income taxable to the beneficiary; therefore, taking funds from an IRA for a charitable contribution could be income tax advantageous to beneficiaries as well as to the taxpayer.
Finally, IRA rules require minimum annual required distributions from IRAs to individuals aged 70 ½ and older; therefore, if distributions are required and the individual is going to make a charitable donation anyway, it makes good sense to consider a qualified charitable distribution from the IRA, whether the distribution is to be $500 or $100,000. Seeking professional assistance in making this decision is critical. IRA distributions must be made for any given tax year by December 31st for the year in which the distribution is planned.
An example below shows the difference in tax consequences of making a charitable donation directly from the IRA versus personally receiving the IRA distribution and then making the charitable donation.
Consider, for example, a married couple, both aged 70½ with income as follows:
Both of the couples were wage earners of which $39,780 is taxable because of the total AGI.
Long Term Capital Gains
Net Rental Income
= Total AGI without Potential IRA Distribution
Potential IRA Distribution
Potential Charitable Donation (using IRA distribution)
By making use of the QCD (direct charitable donation from the IRA), the income tax savings is over $2,000 for the tax year and the potential medicare premium savings is $736.80. This savings is simply from changing the manner in which the donation is made. Tax savings, of course, will vary depending on the amount of the donation and the income and potential deductions of the actual taxpayer(s). Further, of course, is the potential income tax savings to later beneficiaries of the taxpayer's estate. If $100,000 is given to a charity from an IRA rather than from a savings account, then, later, beneficiaries will receive $100,000 more from the savings, which isn't income taxable and will then receive $100,000 less from the IRA which would have been income taxable. Finally, in the above example, adjusted gross income is $169,780 without the IRA distribution and $269,780 with the IRA distribution included in income. By exceeding the $170,000 threshold in the second case, the amount of the future year's medicare premium is accordingly increased by $736.80 as well.
It is most important to remember that even in the most simple and modest of income tax situations, if a taxpayer aged 70 ½ has an IRA, he or she will be required to take a required minimum distribution as prescribed by IRS tables. That will be considered taxable income to the taxpayer. However, if that same taxpayer generally makes annual charitable contributions then even if he cannot or does not itemize his annual deductions, he will be making a tax wise decision to make the charitable donation directly from his IRA, therefore avoiding reporting of that income on his tax return.