Year-End Planning for Charitable Donations

November 25, 2016

The PATH Act, passed at the end of 2015, exempts certain IRA-to-charity transfers from income tax. For most people, moving money from an IRA to a charity is a taxable withdrawal, subject to income tax. However, once you reach age 70½, such transactions may be untaxed as a Qualified Charitable Distribution (QCD).

QCDs are now a permanent tax code provision. Everyone who passes the age test can donate up to $100,000 a year from a traditional IRA to one or more charities. A QCD generally must go directly from the IRA to an eligible charity. (Transfers to donor advised funds can’t be considered QCDs.)

At first glance, QCDs seem to be a wash. You won’t report taxable income, but you also won’t get a tax deduction for the donation. Drilling down,  though, QCDs may offer tax savings  to many seniors.

Itemizing not necessary

Among the beneficiaries from QCDs are the many taxpayers who don’t itemize deductions.

Example 1: Victor and Wendy Young are both age 65 or older, so they qualify for a standard deduction of $15,100 in 2016, as explained previously in this issue. The Youngs have paid off their home mortgage, so they don’t have deductible interest expenses. In retirement, the couple’s income has dropped, reducing the state income tax they pay. Consequently, the Youngs do not have enough deductions to make itemizing worthwhile, so they will take the standard deduction.

Assume that the Youngs typically make $4,000 of charitable donations during the year-end holiday season. Taxpayers taking the standard deduction get no tax benefit from charitable contributions; therefore, if Wendy Young is age 68, she will get no benefit from charitable gifts.

However, suppose that Victor Young is 72 and is eligible for QCDs. Taxpayers older than 70½ must take required minimum distributions (RMDs) from traditional IRAs; assume Victor’s RMD for 2016 is $10,000. The couple would owe tax on that $10,000 RMD on their joint tax return. However, Victor can make their usual $4,000 of charitable donations directly from his IRA, as tax-free QCDs.

Those QCDs will count towards Victor’s RMD, so he’ll only have to take the $6,000 balance in taxable distributions from his IRA, not $10,000. Therefore, the Youngs will save tax by using QCDs. They’ll  retain the $4,000 that would have passed from their checking account to charity, to spend, invest, or use for family gifts.

Adjusting income down

QCDs also can help taxpayers who itemize deductions by reducing their adjusted gross income (AGI).

Example 2: Mary North, age 75, who has a $20,000 RMD this year, plans to itemize deductions. That RMD would increase Mary’s AGI by $20,000, as reported on page 1 of her tax return.

Suppose that Mary will make $15,000 of deductible charitable contributions at year-end 2016. If Mary makes those donations from her regular checking account, the deduction for them would be included in itemized deductions on page 2 of her tax return, without affecting her reported AGI.

Instead, Mary makes her $15,000 of year-end donations as QCDs, reducing her taxable RMD to $5,000, instead of $20,000. By doing so, Mary effectively reduces her reported AGI by $15,000. A lower AGI may provide tax savings throughout Mary’s tax return. She might qualify for a larger itemized medical and dental deduction, for instance, or a larger itemized miscellaneous deduction.

Planning ahead

Although QCDs are limited to people age 70½ or older, the fact that they are now permanent can affect year-end planning for younger people as well. Taxpayers in their 60s, for example, might defer some donations to the future, when they can get the tax benefits of QCDs. That’s especially true for those who don’t itemize deductions, or those who plan large donations and also expect large RMDs.

Taxpayers younger than 70½ also may wish to reconsider year-end Roth IRA conversions. (See the article on Retirement Tax Planning in this issue.) One reason for converting some or all of a traditional IRA to a Roth IRA is to reduce or avoid RMDs because Roth IRA owners never have required distributions. However, year-end Roth IRA conversions will add to your tax bill for 2016 at your highest marginal tax rate.

Some people may decide to forgo a Roth IRA conversion and leave money to grow in their traditional IRA, tax-deferred. Once age 70½ is reached and QCDs are permitted, traditional IRA dollars can go to charity, untaxed, as QCDs. This will reduce the amount of AGI that otherwise would be reported from RMDs. Our office can help you plan for the impact of QCDs on your charitable planning, now and in the future.

Beyond QCDs

If QCDs don’t play a role in your plans, traditional strategies for year-end donations still apply. It often makes sense to donate appreciated securities to charity, rather than write checks. When you donate appreciated securities held for more than a year, you’ll get a deduction for the current value of those securities and avoid paying tax on the unrealized gains.

Donating appreciated securities to many charities can create paperwork headaches, though, so you might want to make those donations through a donor advised fund for the same tax benefit. Donor advised funds are offered by many financial firms and community organizations.