Tap into Little-known tax saving strategies with Qualified Charitable Distributions
With year-end fast approaching, many still have last-minute tax planning items to check off their list. Whether the delay is due to good ole procrastination or waiting to see the results of the election, now is the time to get things done. While there are still many unknowns, tax reform is on the horizon and making moves today might save you significant dollars down the road. One of the proposals on the table is to cap itemized deductions, which won’t impact most people, but could have a substantial implications for those making large charitable gifts. It’s possible that an exception for charitable giving could be implemented, but as a fail-safe, those inclined to make large gifts may consider accelerating their donations to ensure they receive the full tax benefit today.
One of the most popular, but potentially complicated, ways to make a substantial charitable gift is known as a Charitable IRA Rollover, or Qualified Charitable Distribution (QCD). Now permanent, the QCD rule allows taxpayers to make IRA distributions payable directly to a qualified charity without treating the distributions as taxable income, up to $100,000 per year, per individual. In addition, distributions may count toward the IRA owner’s Required Minimum Distribution (RMD), at age 70.5. One caveat when using a QCD to satisfy an RMD is that a RMD is presumed to be satisfied by the first distribution that comes out of the IRA. Consequently, if distributions have been made throughout the year, it’s likely the RMD has already been satisfied for 2016 and will be reported as income. Once distributed, there no way to reverse it and make it a QCD later during that year.
However, the IRA can still be used in 2016 for a QCD and can be a tax advantageous strategy to use in subsequent years, including satisfying the RMD.
There are also several supplementary benefits of a QCD for longer-term planning. Since the QCD lowers the taxpayers Adjusted Gross Income (AGI) by satisfying the RMD, it opens up potential planning opportunities for high-income earners subject to itemized deduction phase-outs, or Pease limitations. An additional benefit of a reduced AGI may also prevent taxpayers from being pushed into a higher marginal tax bracket. It also could potentially help minimize the 3.8 percent investment income tax, tax on some Social Security benefits, or increases on Medicare premiums. Moreover, a lower AGI could also enhance other deductions, such as the miscellaneous itemized deductions subject to 2 percent of AGI and medical expenses subject to 7.5 percent of AGI. For example, Joe needs to deduct $20,000 in medical expenses. Assuming his AGI is $100,000, in this scenario, he will be able to deduct $12,500. However, let’s assume Joe’s RMD for this year is $20,000, which increases his AGI to $120,000. Because the RMD increased his AGI, his deduction of medical expenses decreases $1,500, to $11,000.
One of the more interesting, yet unknown, ways to use a QCD is with after-tax contributions. Some IRAs contain after-tax contributions because income thresholds prevent them being deducted. Therefore, IRAs may contain a blend of after-tax and pre-tax contributions. Remarkably, a QCD receives favorable treatment when aggregating accounts to calculate the RMD. What this means is that the pre-tax contributions are always used first for a QCD, leaving the after-tax contributions in the IRA. You may wonder why this is important. The reason is because the RMD is traditionally calculated based upon a pro-rata percentage of pre-tax and after-tax contributions. As a result, if you are using at QCD to satisfy your RMD, you are effectively minimizing the ordinary income portion of your distributions. If the IRA is reduced to only after-tax contributions, the only tax owed will be on the portion of the distribution that is attributable to tax-deferred growth. The initial contribution, or “basis,” will not be taxed. At that point, it may be possible to convert the remainder to a Roth IRA with minimal tax consequences. In simplest terms, you’ve given away your ordinary income asset, while keeping the tax-favored asset.
As distributions are not reported as taxable income, utilizing a QCD also offers flexibility for those that don’t have the opportunity to itemize.
Looking further into the future, taking advantage of the QCD to make lifetime charitable gifts may also aid in mitigating potential estate taxes.
While there are many nuisances associated with Qualified Charitable Distributions, they may serve as a useful long-term tax planning tool. Most importantly, they are a wonderful instrument to help make large one-time gifts, pledges or donations over multiple years in order to meet your personal philanthropic interests.
As always, please consult with a tax planning specialist and the qualified charitable organization to confirm the necessary procedures before executing a Qualified Charitable Distribution.
Melissa Villegas, CFP, EA, is director of gift planning at Texas Christian University.