Reducing Taxes with Charitable IRA Distributions
Updated: Dec 17, 2018
Retirees who want to reduce their income tax liability can do so by using some or all of their Required Minimum Distributions to benefit their favorite charities.
What is a Required Minimum Distribution?
A Required Minimum Distribution (RMD) is the minimum amount that you must withdraw annually from your retirement account. Generally, you must start taking withdrawals from your qualified accounts, such as IRAs, SEP IRAs, or SIMPLE IRAs, when you reach 70 1⁄2 years old. The RMD rules do not apply to Roth IRAs during the account owner’s lifetime. However, Roth IRAs do require withdrawals by the beneficiaries after the death of the owner.
Account owners are responsible for taking the correct amount of RMDs on a timely basis each year from their accounts or face stiff penalties from the IRS. You can always withdraw more than the minimum amount if you wish. Your IRA distributions will be included in your taxable income if the funds being distributed were deductible at the time you contributed them to the account.
Taxes and Your RMDs
When you put money into your retirement account on a pre-tax basis, you have not yet paid taxes on it. Your account continues to grow tax-deferred until you start to take distributions. To ensure that taxes are eventually paid on this money, the IRS requires you to start taking RMDs (and pay income tax) by April 1st of the year following the year you turn 70 1⁄2.
Of course, not everyone needs their annual RMD for living expenses. For those individuals who are also charitably inclined, up to $100,000 of the RMD from may be distributed directly to a 501(c)(3) public charity each year, which enables you to avoid paying income taxes on the amount. This is known as a qualified charitable distribution (QCD). Employer-sponsored plans do not allow for the QCD option. Also, donor-advised funds, private non-operating foundations, and supporting organizations cannot currently accept QCDs because they are not categorized as 501(c)(3) public charities.
Requirements of the QCD
IRA owners must be 70 1⁄2 years or older to make a tax-free charitable contribution. You can transfer up to $100,000 per year directly to an eligible charity without paying income tax on the transaction. If you file a joint tax return, your spouse can also make a charitable contribution of up to $100,000 per year, meaning couples can exclude up to $200,000 of their retirement distributions from income tax if they donate it to charity. QCDs must be made by December 31st each year in order to exclude the distribution from taxable income. If you transfer more than the maximum allowable amount, the excess distribution is considered income and subject to income tax.
Charitable contributions can only be made from IRAs, not 401(k)s. You would need to roll over funds from a 401(k) to an IRA if you want to make tax-exempt charitable contributions part of your retirement plan. You don’t need to itemize your deductions in order to make an IRA charitable distribution. It is critical, however, that the funds are transferred directly from your IRA to an eligible charity in order to qualify for the tax break. If you first withdraw the money and later donate it, it will not qualify as a tax-free QCD.
Advantages of Charitable Contributions
A $100,000 charitable contribution from your IRA can save you tens of thousands of dollars in taxes, depending on your tax rate. Using even a portion of your RMD for charitable giving can offer huge tax breaks, especially if you already donate to charity. For example, a retiree in the 25% tax bracket who makes an IRA charitable contribution could save $1,250 in taxes. Even a $1,000 contribution could save $250.
Your QCD can come from part or all of your RMD. Also, you can distribute your RMD to multiple charities in the same year. To report a QCD on your form 1040 tax return, you usually report the full amount of the charitable distribution on the line for IRA distributions. Then, on the line for the taxable amount, enter zero (if the full amount was a QCD) and put “QCD” next to it.
QCDs are a great way for retirees to benefit their favorite charities while also significantly reducing their own tax bills.