How to keep the IRS from becoming a major beneficiary of your IRA
By John H. (Jay) Turner, III, Esq.
Few can dispute the popularity of individual retirement accounts (“IRAs”). In fact, there are more than 15 million IRAs in existence today. While there are many great features of IRAs, one downside lies in the taxation of distributions from these accounts. With few exceptions, the assets distributed from an IRA will be taxed as ordinary income to the account holder. With top income tax rates currently above 39%, and the potential for additional state income taxes, some taxpayers turn over nearly half of their IRA distributions to the taxing authorities.
One way to lessen the impact of this taxation is through charitable planning. For people who are charitably inclined, there are some special rules regarding IRAs that may significantly lessen the taxpayer’s overall income tax burden. For people who have reached the age of 70½, there is a particularly effective method of tax planning using a special rule governing distributions to charities.
Under general income tax rules, when an individual makes a charitable gift, the income tax deduction is limited to a percentage of the taxpayer’s adjusted gross income (30% or 50% depending on the type of charity). In other words, if a person had $100,000 in adjusted gross income, the taxpayer would normally be limited to deducting no more than $50,000 in charitable gifts made during the year (no matter how large the charitable gifts were that year). Of course, there may be the ability to carry-over unused charitable deductions in succeeding years; but a taxpayer could not zero out his or her income tax liability though charitable gifting in any one year.
For a taxpayer who has reached the age 70½, he or she can exclude from income the entire amount of a “qualified charitable distributions” (“QCD”) made from an IRA. A distribution is treated as a QCD only if three requirements are met:
(i) The distribution must be made directly by the trustee of an IRA to an eligible charitable organization (i.e., an organization eligible to receive tax-deductible contributions other than supporting organizations and donor advised funds);
(ii) The contribution is the type of contribution that would otherwise qualify for a charitable deduction;
(iii) The individual must have reached age 70½ when the distribution was made.
The benefit to this type of income tax planning is best illustrated by an example:
On December 1, Bob, age 80, makes a distribution of $50,000 directly from his IRA to ARC. For purposes of this example, Bob’s IRA exceeds $1 million and this $50,000 is equal to the required minimum distribution he otherwise is required to take this year. Rather than having to include all $50,000 of this distribution in his taxable income, Bob can exclude it entirely from his income by making the IRA distribution directly to ARC. This approach can be beneficial for several reasons. The distribution to ARC satisfies Bob’s required minimum distribution obligation for the year -- but is not actually included in his income. The direct donation eliminates $50,000 of taxable income Bob would otherwise recognize (i.e., effectively allowing a 100% deduction rather than being limited to 50% deduction from adjusted gross income). This exemption from income potentially reduces the percentage of Bob’s social security income that is taxable that year. Moreover, the exemption from income decreases the effects of gross income limitations which are otherwise applied to personal exemptions and itemized deductions (under current income tax rules, a taxpayer can lose up to 80 percent of the value of his or her deductions due to the phase out rules that apply as a taxpayer’s income increases).
The total qualified charitable distributions for any one year cannot be greater than $100,000 (no matter how many IRAs an individual has). For married individuals filing a joint return, the limit is $100,000 per individual IRA owner (i.e., $200,000 if both have IRAs). A check from an IRA that is made payable to a charity and delivered by the IRA owner to the charitable organization is considered a direct payment by the IRA to the charitable organization. Like other charitable gifts, an individual making a charitable contribution using IRA funds must obtain a contemporaneous written acknowledgement of the contribution to benefit from this provision.
A taxpayer cannot claim a charitable contribution deduction for the qualified distribution. This makes sense as the qualified distributions are not included in the taxpayer’s gross income (in other words, a taxpayer cannot claim a double tax benefit by taking a charitable deduction). A qualified charitable distribution is not subject to withholding as the IRA owner is deemed to have elected out of such withholding.
The exclusion from income is also available for distributions from an IRA maintained for the benefit of a beneficiary after the death of the IRA owner (i.e., an inherited IRA) if the beneficiary has attained age 70 1/2 before the distribution is made to the charity.
These IRA rules are particularly attractive to higher income taxpayers who are charitably inclined and who would otherwise lose certain exemptions or deductions due to the phase out limitations. For individuals who are charitably inclined, a qualified charitable deduction will result in a win-win to the taxpayers and charity – leaving only Uncle Sam on the short end. Qualified charitable distributions can also be effective for lower income taxpayers who want to benefit a charity; it could eliminate any income tax on social security received and reduce future Medicare premiums.
For more information on charitable planning and how you can leverage Qualified Charitable Distributions, please contact Kim Watson, Vice President for Development and Communications (E-mail: Kim.Watson@RichmondARC.org Phone: 804-358-1874) or Bob Sommerville, Chair of the Development Committee (E-mail: firstname.lastname@example.org Phone: 804-347-2568).
John H. (Jay) Turner, III, Esq. is a partner and co-founder of Shepard & Turner, PLC, an estate planning law firm in Richmond, Virginia (www.vaestateplanning.com). Jay focuses his practice on estate planning and administration with an emphasis on estate, gift, generation- skipping and fiduciary income tax planning. Prior to co-founding Shepard & Turner, PLC, Jay was a partner with Williams Mullen and served as chair of the firm’s estate planning section. Prior to joining Williams Mullen, Jay served as Senior Counsel in SunTrust Bank’s legal department.