Why Donating Your Required Minimum Distribution (RMD) Directly to a Charity Can Save You Money

Article By: Jeff Skolnick, CPA, M.S. Taxation

In order to fully understand this tax saving strategy, I will explain a little bit about how both the RMD and charitable contributions rules work. Do not be alarmed I promise I am going to break this down so it is very easy to understand the overall concept.

RMDs

I want to start off by explaining what an RMD is and how it can impact your tax return. RMDs are, as mentioned in the title Required Minimum Distributions. 

The beauty of most retirement plans is that they allow you to put aside for your retirement and not be taxed on this money when contributed. The money is considered tax deferred. In other words, you will eventually pay tax on that money but not until you pull the money out of your retirement account years down the road. This typically will create a deduction on your individual return if you are using a vehicle such as a traditional IRA. In 2019, individuals may place up to $6,000 ($7,000 if age 50 or older) in an IRA account. Assuming the individual meets the tests in order to deduct the IRA, then the individual will pay less tax in 2019 as their income would be reduced by the IRA.

There comes a point in time where the government says you’ve deferred taxes on this money long enough and now you must start to pay tax. Let me explain how this works.

The general rule is you must take a distribution by April 1 of the year following the calendar year in which you reach age 70 ½. If you would like a little more information on RMDs I have written an article on RMDs in the past and have also done a podcast on this topic which can be found through Spotify or Apple podcast.

Qualified Charitable Distributions

The definition provided in IRS Publication 590-B Distributions from Individual Retirement Arrangements (IRAs) is as follows:

“A qualified charitable distribution (QCD) generally is a nontaxable distribution made directly by the trustee of your IRA (other than a SEP or SIMPLE IRA) to an organization eligible to receive tax-deductible contributions. You must be at least age 70½ when the distribution was made. Also, you must have the same type of acknowledgment of your contribution that you would need to claim a deduction for a charitable contribution.”

All that means, in English, is that IRAs, including rollover IRAs are eligible for this strategy. A rollover IRA is an IRA where you’ve moved funds from your old employer-sponsored retirement plan to an IRA. This could occur if you had a 401k with an employer and then left the company. You would be allowed to roll that money over to a personal IRA and still keep its tax deferred status. In other words, you could take it from your ex employer’s retirement plan move it to an IRA and still not have to pay tax on it until you reach age 70 ½. 

The way a deduction to a QCD would work is best illustrated with an example. Let’s say an individual is over age 70 ½ and therefore required to take an RMD from his/her IRA of $5,000. Let’s also assume that this same individual would like to make a $5,000 charitable contribution to a charity. Normally, without the use of a QCD, the individual would report the $5,000 income on page 1 of their tax return and a $5,000 charitable contribution on Schedule A of that same return. 

There are a number of income tax issues that can be caused by this situation and while I will outline a few more shortly, I want to concentrate on just the deductibility of the donation first. In the example I am currently discussing assume that the individual in question is married and filing a joint return. The standard deduction for 2019 is $24,400.  If the couple in question has no deductible medical expenses (remember in order to deduct medical expenses they must exceed 10% of your Adjusted Gross Income (AGI)), has deductible taxes of $10,000 (the current maximum), then unless their charitable contributions and mortgage interest exceed $19,400, then they are probably not receiving the full benefit of the charitable contribution. Remember they are already receiving a deduction for $24,400 so in order to receive the full benefit of the $5,000 they would need to reach $29,400 and as I stated they have $10,000 in deductible taxes. Most people will not reach this level and will therefore lose some of the benefit of making this contribution while still being taxed on 100% of the RMD income. I say probably will not reach $29,400 because there are some other ways to receive itemized deductions, but I am concentrating on the most common itemized deductions for purposes of this discussion.

If a QCD is used, then the individual would have their RMD transferred directly from their IRA to a charitable organization. The result, using the same facts from my previous example would be to net the $5,000 RMD and the $5,000 charitable contribution. In other words, the $5,000 RMD would not show up on page 1 of the income tax return and the $5,000 donation would not show up as an itemized deduction on Schedule A. This means individuals are receiving the benefit of the donation whether they itemize their deductions or not. There is no requirement that the total RMD is used for charitable purposes. A taxpayer can elect for example to donate $4,000 of their $5,000 RMD and receive the other $1,000 themselves. In this situation only the $1,000 would show up on page 1 of the individual return.

There are some rules that must be followed in order to use a QCD, the main ones are as follows:

• No more than $100,000 may be excluded per taxpayer per year. Married couples filing jointly may each exclude up to $100,000 per year.
• The charitable contribution must be made from an IRA, including inherited and rollover IRAs. It cannot be taken from an active SEP or simplified retirement plan. It also cannot come from a non-IRA (such as a 401k or 403(b) plan although you may be able to roll these amounts into an IRA and then use them). You could pay a charity directly from a Roth IRA, but it would not be advisable. A Roth IRA would not be taxable and therefore there is no offset.
• The distribution to the charitable organization must come directly from the IRA trustee. If the distribution is made to the individual and the individual then makes the charitable contribution, then this strategy will not work.
• The distribution cannot be made until the taxpayer has reached age 70 ½.
• The taxpayer cannot take the charitable contribution as an itemized deduction since it has already offset income and that would be taking the same deduction twice.
• Taxpayers are required to satisfy the same substantiation requirements as if they were taking the itemized deduction. For example, for contributions of $250 or more written acknowledgement must be available.

Other Benefits of QCDs

I have already mentioned that by using QCDs you may be able to reduce your income even when you cannot itemize your deductions but there are other benefits.

The other benefits that a taxpayer may enjoy come from the fact that when you offset an RMD with a charitable contribution it will reduce your AGI. AGI is used for a number of different calculations and I will list some of the more common benefits:

As much as 85% of social security income may be taxable income. If you receive $20,000 in social security income anywhere from $0 to $17,000 may be considered taxable income. The calculation is based on your total income. The fact that you can offset the RMD income will possibly make less of your social security income taxable.

Your AGI being reduced may increase the chances of you being able to itemize your deductions. Medical expenses are only deductible once they exceed 10% of your AGI. If AGI is reduced it lowers the bar for deductible medical expenses. 

Taxpayers over a certain income amount are subject to a 3.8% tax on investment income. These taxpayers are in higher income tax brackets (income in excess of $200,000 for individuals filing as single or head of household, $250,000 for married couples filing jointly and $125,000 each for those married couples filing separately). While this tax applies to higher income taxpayers keep in mind each taxpayer can reduce an RMD by up to $100,000. Th use of a QCD can reduce, or possibly eliminate, this tax.

Medicare premiums for those receiving social security are based on your income from two years ago. If you reduce your AGI now it may have an impact on the amount of Medicare premium you pay a couple of years down the road.

Conclusion

QCDs are a valuable tax savings tool and should be researched fully if you are both receiving an RMD and wish to make a charitable contribution in the same year. There are a plethora of rules, benefits and consequences that must be examined. For these reasons I urge you, as always, to consult with a tax professional well versed in this area of the law.

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