Max Out Tax Savings Using a Qualified Charitable Distribution
In my last column two weeks ago, I discussed the hit to the charitable contribution deduction from recent tax reform. In doing so, I briefly touched on the use of a qualified charitable distribution (QCD) to minimize that impact and maximize tax savings, with the promise to dig into this planning tool deeper this time.
Basically, it works like this; if you are age 70Ω or older, you can make donations directly to charity out of your Individual Retirement Account (IRA). To take maximum advantage of a QCD, you can use it to replace some or all your IRA required minimum distributions (RMD). This effectively reduces your taxable income for the year, giving you a tax benefit from the donation even if you do not itemize your deductions due to the higher standard deductions under tax reform (see the article, "Tax Reform's Hit on Charitable Giving").
To qualify, there are some rules you must follow.
QCDs can be taken out of your traditional IRAs free of federal and many states, income tax. In contrast, other traditional IRA distributions are taxable (wholly or partially depending on whether you've made any nondeductible contributions to it).
Unlike typical charitable donations, you cannot claim itemized deductions for QCDs. No problem, though, since the tax-free treatment of QCDs equates to a 100% deduction. You will never be taxed on those amounts, and you do not have to worry about any of the restrictions that apply to itemized charitable deductions as discussed in the earlier article.
A QCD must meet all the following requirements:
ï It must be distributed from an IRA, and it cannot occur before you, as the IRA owner or beneficiary, reach age 70Ω. This includes an IRA inherited from the original owner.
ï It must meet the normal tax-law requirements for a 100% deductible donation. If you receive any benefit that would be subtracted from a donation under the normal charitable deduction rules (such as free tickets to an event), the distribution cannot be a QCD. Big red flag of caution here!
ï It must be a distribution that would otherwise be taxable. A Roth IRA distribution can meet this requirement if it is not qualified (tax-free). However, making QCDs out of Roth IRAs is generally inadvisable for reasons explained below.
There is also a $100,000 limit on total QCDs for any one year. But if you and your spouse both have IRAs set up in your respective names, each of you is entitled to a separate $100,000 annual QCD limit.
QCDs have at least four potential tax-saving advantages:
1. QCDs aren't included in your adjusted gross income (AGI). This could mean less of your Social Security benefits are taxed, more of your rental estate losses are possibly deductible, and less of your investment income may be subject to the 3.8% net investment income tax, since these things are tied to the amount of your AGI.
2. As mentioned, a QCD from a traditional IRA counts as a distribution for purposes of the RMD rules.
3. QCDs are treated as coming from the taxable layer of your IRA balance. For example, if you own one or more traditional IRAs to which you have made nondeductible contributions your IRAs consist of a taxable layer (from deductible contributions and account earnings) and a nontaxable layer (the nondeductible contributions). QCDs come from the first, taxable layer. Any nontaxable amounts are left in your IRAs. Those nontaxable amounts can be withdrawn later tax-free by you or your heirs.
4. QCDs reduce your taxable estate, although that's not an issue for most folks right now since tax reform increased the federal estate tax exemption for tax years 2018 through 2025 to over $11 million per person.
So is a QCD right for you? As with many things, it depends.
In general, if you are someone for who reducing AGI would be beneficial as discussed above or who will not benefit from taking itemized deductions due to the increased standard deductions, then most likely you should consider using this technique. As I mentioned last time, we have seen clients save several thousand in tax by using a QCD to fund donations that they were going to make one way or the other.
One last question often asked is should a Roth IRA be used for a QCD. The answer is, generally no. The reason is this fairly simple. You and your heirs can take tax-free Roth IRA withdrawals after at least one Roth account owned by you has been open at least five years. Also, for original account owners (not beneficiaries), Roth IRAs aren't subject to the RMD rules until after your death. Thus, because the tax rules for Roth IRAs are so favorable, it is generally best to leave Roth balances untouched rather than taking money out for QCDs.
You probably can see now that tax reform has altered the playing field for charitably-minded folks. The use of QCDs can be a tax-smart opportunity for seniors with IRA money to make their desired donations.