For many retirees, the burden of meeting a required minimum distribution is an unwelcomed but necessary event. This is an annual requirement that forces a taxable distribution from an otherwise tax-deferred account.
Unfortunately, the penalty for not taking the distribution is severe: 50% of what should have been withdrawn.
For retirees who find themselves in a situation where they are forced to take a larger withdrawal than what they would prefer to take AND are charitably inclined, a qualified charitable distribution may be a good strategy.
What Is a Qualified Charitable Distribution from an IRA?
In short, a qualified charitable distribution allows you to donate your RMD to charity.
More specifically, a qualified charitable distribution allows an IRA owner to still meet the annual required minimum distribution rules by making a direct transfer from their IRA account to a qualified charitable origination.
By doing this, the IRA owner avoids actually receiving their distribution. The result of a QCD is that the distribution is now a non-taxable event for the IRA owner. In addition, the IRA owner has the benefit of having made a contribution to charity.
Requirements for a Qualified Charitable Distribution
The rules regarding a QCD are very specific and must be followed to obtain the intended result of giving money to charity while keeping the income off your tax return.
To do so, the following list of requirements should be met:
- You must be at least 70.5 years old when the distribution is made. (You cannot simply turn 70.5 in the year of the distribution. You must already be 70.5 years old.)
- The maximum annual QCD is limited to $100,000 per year per tax-payer. (Spouses can contribute $100,000 each for a household total of $200,000.)
- Only distributions from an individual IRA are eligible. Distributions from an employer-sponsored retirement plan are not.
- Distributions must be donated to a qualified public charity. Distributions will not qualify if they go to a private foundation or a donor-advised fund.
- The distribution must be one that would have otherwise been eligible for a full charitable distribution had the QCD not been performed and the money had simply been given to the charity outright.
- Distributions must be paid directly to the charity (and if the goal is to make 100% of the distribution nontaxable, withhold at zero percent). The distribution MUST be made payable to the charity directly in order for the taxpayer to receive the deduction.
- The check must be sent directly to the charity or forwarded to it upon receipt.
Burst of Knowledge: See the flow chart detailing qualified charitable contributions (from Michael Lecours, CFP)
Benefits of a Qualified Charitable Distribution
There are several potential benefits of a qualified charitable distribution. Before discussing those, however, it’s important to keep in mind one key factor. A QCD may make sense from a numbers standpoint, but in order to work and to work well, an IRA owner should first be charitably inclined.
It’s important to know that by performing a QCD, an IRA account owner is giving up their own money and giving it to charity. This means they no longer have control or access to the money. Furthermore, since it is no longer a part of their estate, it will not be passed to the next generation.
While this seems obvious on the surface (a gift is a gift), it’s an important part of the conversation. No matter what the additional benefits that are available may be, they likely mean little if the IRA owner is not charitably inclined.
With that said, let’s explore several potential benefits of a qualified charitable distribution.
- Satisfies the Annual Required Minimum Distribution
As mentioned above, performing a qualified charitable distribution satisfies the requirements of a requirement minimum distribution. An RMD is the amount an IRA owner is required to take out of their IRA when they reach 70.5 years old. If they do not do this, the penalty is stiff at 50% of what should have been taken out.
A qualified charitable contribution will satisfy the annual requirements of an RMD.
- Keeps You at a Lower Tax Rate
When money is distributed from an IRA, it is taxed as ordinary income to the IRA owner (assuming there are not after-tax dollars in the account). Typically, distributions from an IRA as a result of an RMD are included in gross income on your annual 1040. All else being equal, an RMD will increase your adjusted gross income on your tax return.
A QCD is a reportable event for which the taxpayer will receive a 1099-R at year end, just like they would have otherwise received had they withdrawn the money outright. The 1099 will report the gross distribution as well as the taxable distribution. If you meet the requirements of a QCD, the taxable distribution should be zero.
Because the taxable distribution is zero, the QCD has the net impact of lowering the taxpayer’s total adjusted gross income.
- May Be Advantageous for Social Security and Medicare Premiums
As discussed above, a qualified charitable contribution is not included as income on the IRA owner’s tax return.
A lower adjusted gross income may impact both the taxability of Social Security and the required premiums for Medicare, both of which are subject to change according to the adjusted gross income of the IRA owner.
- May Lower Future RMDs
When performing a QCD from an IRA, one may think only of transferring the annual RMD to a charitable organization. However, the rules in place for a QCD allow for annual distributions of up to $100,000 per account owner.
An additional planning thought could be to consider maximizing an annual qualified charitable distribution in one year (or for several years), subsequently lowering your overall IRA account balance. A lower IRA account balance could lead to a lower RMD in the future.
Example of a Qualified Charitable Distribution
In a previous article detailing what retirees should know about RMDs, a hypothetical example of a 70.5-year-old with a $1,000,000 IRA balance was used. In this example, the first RMD would be $36,394.45.
If this IRA owner wanted to make a QCD, they would have one of three options:
1 – Do a QCD for some of the RMD, and take the rest as income.
In this scenario, a portion of the distribution would be non-taxable and the other portion would be taxable income. For example, if $20,000 was distributed as a QCD, the remaining $16,394.45 would be taxable income for the taxpayer.
2 – Do a QCD for the full amount of the RMD.
In this scenario, the full amount of the $36,394.45 would be non-taxable for the tax-payer. If we assume a 25% tax bracket, this transaction would have saved $9,098.61 in income taxes (without any regard to the impact on other figures).
3 – Do a QCD for the taxpayer’s maximum allowable amount of $100,000 per calendar year.
In this scenario, the full amount of the $100,000 QCD would be non-taxable. Furthermore, the expected year-end account balance would be lower when compared to option 2 above (all else being equal). Because of this, the following calendar year RMD would then be lower.
Example of a QCD for an IRA With Non-Deductible Contributions
The above example is a simple example of a QCDs for an IRA that has a zero basis. However, it is not uncommon for an IRA owner to have after-tax dollars (or non-deductible contributions) in an IRA.
Typically, when distributions occur from an IRA with non-deductible contributions, the distribution is prorated so a portion of the money received is taxable and a portion of it is a tax-free return of your own money.
However, the rules regarding QCDs for non-deductible IRA dollars are different. For a QCD, the pro rata rule does not apply. In fact, the first dollars of a QCD are what would otherwise be taxable dollars. In effect, this keeps the after-tax portion of the IRA balance intact. Let’s explore:
Following our example above, let’s assume the 70.5-year-old has $20,000 of after-tax (non-deductible) dollars in the IRA.
In this situation, if the IRA owner were to take a distribution directly from the IRA, payable to himself, a portion of the money would be taxable and a portion would be a tax-free return of income. Specifically, 2% would be a tax-free return of income and 98% would be taxable income. The calculation is as follows:
Tax-Free Amount = After-Tax Amount / Previous Year’s Account Balance
$20,000 / $1,000,000
2% x $36,394.45 = $728
In this example, $728 would be tax free, and the remaining $35,666 would be taxable. In future years, the after-tax basis of the IRA would be lowered from $20,000 to $19,262.
We can compare this to an example when a QCD is performed. In this scenario, the full $36,394.45 will be given to charity and will be non-taxable. Furthermore, the after-tax basis of the IRA will remain the same at $20,000.
If you find yourself in a situation where you are forced to take RMDs in excess of your need AND want to contribute to charity, a qualified charitable distribution may be a good strategy to keep your adjusted gross income lower, pay lower taxes, and still fund your charitable intentions.
To do so correctly and to be sure this strategy fits with your plan, it may be a good idea to consult with an expert who can help identify if this is the best giving strategy for you, if this fits into your financial plan, and if you are processing the distribution the best way possible to be sure you obtain the maximum benefit.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.