The Tax Cuts and Jobs Act (the “Act”) may take the Qualified Charitable Distribution (QCD), a planning technique authorized in IRC Section 408(d)(8) that allows charitable contributions to be made directly from an IRA, and turn it into a household name. Here is an explanation of why it will be so popular, and exactly how it works.
Who will find QCDs attractive?
(i) you are already over 70 ½, or will be during 2018;
(ii) you make charitable contributions; and
(iii) you no longer have a mortgage or have only a small mortgage;
then you are a candidate for QCDs.
Why will you find QCDs attractive?
In 2018, under the Internal Revenue Code as amended by the Act, you can either itemize deductions or take a standard deduction which has been increased to $24,000 for married couples filing jointly (and $12,000 for single taxpayers). (This article will address joint filers, but the conclusions are equally applicable to single taxpayers.)
Under the Act, there are only 3 categories of itemized deductions that will apply to most people.
A. The first category is state taxes, but the maximum amount that can be an itemized deduction is limited to $10,000.
B. The second category is mortgage interest, which will be zero for an over-70 ½ couple with no mortgage.
C. The third category is charitable contributions.
A fourth category, medical expenses, is also available, but it only includes medical expenses in excess of 7.5% of Adjusted Gross Income (AGI). Most Medicare eligible taxpayers with substantial AGI will not meet this annual threshold. This article assumes that your medical expenses will not result in any itemizable deductions.
Assuming that you and your spouse pay at least $10,000 in state and local taxes, if you and your spouse contribute less than $14,000 of charitable contributions, your total itemized deductions will be less than the standard deduction. This means your charitable contributions are essentially being made from after tax dollars and do not reduce your income tax at all. In this article, we will characterize those contributions as “tax inefficient”.
If you and your spouse do contribute more than $14,000 of charitable contributions, your total itemized deductions will exceed the standard deduction – but the first $14,000 of your charitable contributions are tax inefficient, because they are being used to get a deduction that you would otherwise get from the standard deduction. Only the excess of your charitable contributions over $14,000 is having the effect of reducing your tax below what it would have been if you had taken the standard deduction (what we would call “tax efficient”).
Is there a way to use the standard deduction, and still get tax efficient charitable contributions?
Yes. You can make your charitable contributions directly from your IRA, using the mechanism of QCDs, and those QCDs will either reduce your taxable Required Minimum Distribution (RMD) for the year, or (if the charitable contributions exceed your RMD) will use up pre-tax dollars that will otherwise be taxed in the future. Either way, the charitable contributions are tax efficient. We will give an example below.
In addition to making efficient charitable contributions, QCDs have the added benefit of reducing a taxpayer’s Adjusted Gross Income (AGI) because the amount of the RMD that is paid out in a QCD is not included in AGI. An itemized charitable deduction does not similarly reduce AGI. This may be beneficial in eliminating the 3.8% tax on net investment income which is tied to AGI. In addition, a lower AGI may reduce Medicare premiums and provide a lower base for determining whether medical expenses are deductible.
What if my spouse and I do not have at least one IRA?
QCDs can only be made from IRAs with pre-tax money – not from Roth IRAs.
QCDs cannot be made from qualified plans. If you are a participant in a qualified plan, such as a 401(k) or 403(b) program, you can roll over all or part of your account (except for that year’s RMD that is required to be taken from the plan, if any) into an IRA for this purpose. If you have neither an IRA nor a qualified plan which can be rolled over to an IRA, you are out of luck and need not read any further.
What are the details about QCDs?
Qualified charitable contributions have been around for more than a decade, but for most people, itemizing deductions was the easiest way to make charitable contributions tax efficient. In 2018, with the increase to the standard deduction and the cap on the deductibility of state taxes, we think that QCDs will become much more popular.
Basically, the law permits someone who is over 70 ½ to instruct her IRA custodian to make a charitable contribution as a direct distribution out of her IRA. As an example, Emma could say to her custodian: “Pay $3,000 to the United Way of Greater Hartford.” The charity must be a “501(c)(3) organization”. Most charities are – but, for example, you cannot contribute a QCD to a donor advised fund that you established. In Emma’s case, the custodian will issue a check payable to the United Way of Greater Hartford, and either send it to Emma for further delivery to the United Way, or send it directly to the United Way, indicating that Emma is the donor. This is a QCD.
Because Emma is already over 70 ½, she is required under the Internal Revenue Code to receive a taxable distribution from the IRA by year end (or by April 1 of next year if it is the year in which she became 70 ½). This is called a Required Minimum Distribution (RMD). Emma’s QCDs will reduce, on a dollar-by-dollar basis, the amount of the RMD that she is otherwise required to take in cash and include in taxable income. So if Emma’s RMD for 2018 is $4,000, the $3,000 that is going to the United Way of Greater Hartford will be “credited” toward that amount, and she will only have to take another $1,000 in cash as a taxable distribution to satisfy her RMD. This makes the charitable contribution tax efficient by reducing taxable income for the current year.
What if Emma instead wants to give $10,000 to the United Way of Greater Hartford? She still can do it. She is limited to $100,000 in total QCDs from all of her IRAs for any given year (or her IRA balance if less), but the RMD amount is not a limitation. (The $100,000 limit is per taxpayer, so if Emma’s spouse is also over 70 ½, each spouse can make up to $100,000 in QCDs.) The QCD in excess of her RMD is still tax efficient. Although it is not saving her any additional income tax for 2018 beyond the tax otherwise due on her RMD, she is nevertheless paying her charitable contribution in pre-tax dollars, because the extra $6,000 distributed from her IRA, which eventually would have been taxable income to either her or her beneficiary, now will never be taxed.
What are the limits on QCDs?
As noted, the total QCDs per individual for a given calendar year cannot exceed $100,000. In addition, the QCD must be made from pre-tax dollars. It cannot be made from a Roth IRA or from after-tax dollars in a traditional IRA. But as noted above, for a married couple where each spouse is over 70 ½ and has an IRA, up to $100,000 of QCDs can be made by each spouse per calendar year.
In addition, you must be over 70 ½ when you make the QCD. If, for example, Emma turned 70 ½ on June 16, 2018, she cannot make a QCD before that date.
How do you go about making QCDs?
Your institutional custodian for your IRA is set up to make QCDs for you. Just go online, and you will find a form to be used for that purpose. It will require you to give the exact name of the charity, and perhaps a contact (“to the attention of…”). The custodian will either send the QCD check directly to the charity, or send you the check from your IRA, made out to the charity for you to deliver. You probably will want to follow up to make sure the funds were received by the charity.
Will this present complications for your tax preparer?
QCDs should not present any problems for your tax preparer. After the end of the year, you will receive a 1099R from your IRA custodian which will show the total distribution from the IRA. The instructions to Form 1040 indicate that you report the total amount on line 15a. Then you report the taxable amount on line 15b. If the entire distribution consisted of QCDs, line 15b will be zero.