Why You Should Make Charitable Contributions from Your IRA

Congress finally delivered good news to individual retirement account (IRA) owners late in 2015. The Protecting Americans from Tax Hikes Act of 2015 (PATH) made permanent the qualified charitable distribution (QCD) from IRAs for taxpayers ages 70½ and older. The QCD, one of the best ways to make charitable gifts, has been in and out of the law since 2006. Now, taxpayers can reap the benefits of adding it to their regular tax planning, including planning QCDs early in the year.

When the QCD rules don’t apply, a charitable contribution made with IRA funds is first treated as a distribution to the owner. It doesn’t matter if the contribution is made by a direct transfer from the custodian to the charity, or if a distribution is made to the IRA owner who then makes a charitable contribution. In either case, the amount is included in the gross income of the owner as a distribution.

The owner might be entitled to a charitable contribution deduction as an itemized expense on Schedule A to offset the income. Many people over age 70½ don’t deduct charitable contributions, because they don’t itemize deductions. They no longer have mortgages, so their itemized expenses don’t exceed the standard deduction.

Even when you can deduct the charitable contribution,  there still are negative tax effects from making a charitable contribution from an IRA when the QCD isn’t available. Including the distribution in gross income increases adjusted gross income. That could increase or trigger the stealth taxes. Among the stealth taxes are the inclusion of Social Security benefits in gross income, the Medicare premium surtax, the phaseout of personal and dependent exemptions, reduced itemized expense deductions, the alternative minimum tax and the 3.8% surtax on net investment income. There are other tax breaks that are lost or reduced as income rises.

So, even when a charitable contribution deduction offsets the amount of the IRA Distribution included in gross income, there can be other negative tax effects from having to include the amount in gross income.

So, even when a charitable contribution deduction offsets the amount of the IRA distribution included in gross income, there can be other negative tax effects from having to include the amount in gross income.

Under a QCD, the charitable contribution made from the IRA isn’t included in the gross income of the IRA owner. Excluding the charitable contribution from gross income means there is no risk it will trigger any of the stealth taxes. The owner also doesn’t take a deduction for the contribution.

In addition, the QCD counts toward the required minimum distribution (RMD) for the year. RMDs increase gross income and can by themselves increase income taxes and the stealth taxes. Instead, a charitably minded taxpayer can take care of the RMD and charitable contributions with the same move. Suppose your RMD for the year is $17,000. Make at least $17,000 of QCDs and you’ve satisfied both your RMD and $17,000 of your charitable giving for the year. There’s no gross income on your tax return from the RMD. You don’t deduct the QCDs as charitable contributions.

A QCD can be a good strategy during a year when a traditional IRA is being converted to a Roth IRA. In the year of the conversion, you still are required to take your RMD for the year, regardless of when during the year the conversion is done. You won’t be able to convert the RMD amount. Without the QCD, you’d have to include the RMD in gross income along with the converted amount. The alternative is to make a QCD with the RMD amount. That keeps the RMD amount from your gross income.

You have to meet certain requirements to take advantage of the QCD.

The charitable contribution must be made directly from the IRA custodian or trustee to the charity. If you receive a distribution from the IRA and later make a contribution to charity, that doesn’t count as a QCD. The distribution will be included in gross income.

The IRA custodian can give you a check that is payable to the charity, and you can deliver that check to the charity. That will count as a QCD.

You must be at least age 70½ by the date of the charitable contribution. If you turn 70½ during the calendar year, transfers made from the IRA to a charity before that date don’t count as QCDs. You have to wait until reaching the milestone for the charitable transfers to count.

QCDs are limited to no more than $100,000 annually per taxpayer. No matter the amount of your RMD for the year, you can give up to $100,000 to charities from your IRA. The $100,000 will receive QCD treatment when all the requirements are met (and reduce future RMDs by trimming your IRA balance). If your charitable giving from the IRA for the year exceeds $100,000, there is no carryover of the excess amount to future tax years. Instead, the contributions from the IRA above $100,000 are treated as non-QCDs as described early in this article. The contributions from the IRA above $100,000 are included in the gross income of the IRA owner as a distribution, and the owner might be able to take a charitable contribution deduction.

The $100,000 annual limit is per taxpayer. There is no sharing of the limit between taxpayers. For a married couple to have $200,000 of QCDs for the year, each spouse must have IRAs worth at least $100,000 and give $100,000 from his or her IRAs. If only one spouse has IRAs, he or she has only the $100,000 QCD limit and the other spouse’s QCD limit can’t be used.

A QCD can be made only from an IRA. Employer retirement plans aren’t eligible for QCDs. Also, QCDs can be made from simplified employee pensions (SEPs) and Simple IRAs only when the plan hasn’t received an employer contribution for the plan year that ends with or during the calendar year in which the IRA owner plans to make the charitable contribution from the IRA.

Roth IRAs technically are eligible for QCDs, but not as a practical matter. That’s because after-tax money can’t be used to make a QCD. All or most of the money in a Roth IRA is after-tax money. Also, there is no benefit to making a QCD from a Roth IRA, because the distribution is likely to be tax-free anyway.

Likewise, after-tax contributions in a traditional IRA can’t be used to make a QCD. Only pre-tax money in the traditional IRA can be used to make a QCD. Unlike in other situations, the after-tax and pre-tax money in the traditional IRA can be segregated and designated. In other situations, taking money out of the traditional IRA would be automatically pro-rated between pre-tax and after-tax money.

When your IRA has a mix of pre-tax and after-tax money and you use the pre-tax money to make a QCD, that leaves less pre-tax money in the IRA to be taxed in future years to be distributed or converted to a Roth IRA.

The IRA owner can’t receive any benefit from the charitable contribution. Any small gift or reward from the charity could make the entire contribution ineligible for QCD treatment. A QCD, however, can be used to satisfy a pledge the IRA owner made to the charity.

All the regular rules for substantiating charitable contributions must be followed. That means the IRA owner should have documentation in writing from the charity acknowledging the amount and date of the contribution.

QCDs can be made only to public charities that are eligible for charitable contribution deductions under the regular IRS rules. Not eligible for QCD treatment are gifts made to private foundations, donor-advised funds, and charitable gift annuities.