Tax Benefits of Charitable Giving
The Annual Report on Philanthropy from Giving USA estimates that individuals gave $324.10 billion to US charities in 2020. This was an increase of 2.2% year over year from the 2019 report. Despite all of the negative news the media likes to focus their attention on, America is a very generous country. However, I run into many people that are uncertain about how to maximize the tax impact of their charitable giving. There are a few key points at play.
-It’s estimated that older generations will transfer $70 trillion of wealth between 2018 and 2042 as a result of diligent savings and investing throughout their lifetimes.
-In 2017 the Tax Cuts and Jobs Act passed, which doubled the standard deduction. This is the amount individuals and couples can deduct automatically on their tax return. This led to fewer people itemizing their charitable donations.
-Finally, the SECURE Act of 2019 has increased the tax liability on qualified retirement plans that pass on to the next generation.
As a result of all of these factors, many of my clients are interested in giving to charity during their lifetime, but at the same time finding ways it could improve their tax situation during their life as well as for their heirs. QCD stands for Qualified Charitable Distribution, and DAF stands for Donor Advised Fund. There are other ways to donate to charity by way of private foundations, establishing special trusts or gifting outright. However, this article will focus on QCDs and DAFs as they are the most common solutions I see used for my clientele. I hope you find it helpful!
Let's first talk about Required Minimum Distributions
When you turn 72, of 70 1/2 before 2020, you are required to take a portion of your qualified retirement plans as a distribution by way of the “Required Minimum Distribution,” or RMD. The amount required is based on a life expectancy table published by the IRS. Most individuals use the table below, unless their spouse is sole beneficiary and is more than 10 years younger. The RMD is calculated by dividing your year end account balance as of December 31st, and simply dividing it by the Distribution Period associated with your age. Example: Let’s say your IRA account balance at the close of the previous year (December 31st) was $1,000,000, and you are turning 75 this year. You will take $1,000,000 and divide it by 22.9, which gives you $43,668.12. That is the amount you will be required to withdrawal before the year is over.
You will notice that each year, the Distribution Period becomes smaller, and therefore the amount required to be withdrawn goes up. If you turned 90 with a $1mm IRA, you would be required to withdrawal $87,719.30! This equates to almost 9% of the account balance. One exercise I will run through with my clients well before turning 72 is to calculate their projected RMD each year during retirement, and compare that to how much they will actually spend for their retirement lifestyle. Over time, I often see the RMD increases at a much higher rate than annual spending, therefore creating a surplus in income over time.
A common complaint I hear: “The IRS is making me take out all of this income I don’t need!” If you want to minimize the tax impact on unnecessary withdrawals, thoughtful planning must be introduced years before turning 72. I often tell my clients that retirement income planning begins at least a decade before they retire in order to optimize their financial plan.
All retirement plans including 401ks, 403bs, 457bs, other defined benefit plans and traditional IRAs have RMD requirements. Roth IRAs do not have RMDs while the owner is alive. Roth 401ks, however, do have RMD requirements. Therefore, many people opt to rolling over their Roth 401ks to their own Roth IRA once they have attained eligibility requirements to avoid the RMD.
It’s critical to satisfy RMD requirements, otherwise you will be hit with a 50% penalty on the funds you did not withdrawal on time. Example: If your RMD amount was $50,000 and you failed to take any money out, you could be responsible to pay a penalty in the amount of $25,000!
If you turn 72 and are actively employed, RMDs associated with their employer plan could be eligible for deferral. Any other accounts not affiliated with that active employer will still have an RMD. Once you separate from service from that employer, you will then begin taking RMDs based on your attained age for that year. For your first RMD, you have the option to defer the distribution until April of the following year. This is helpful if you expect your tax rate to go down the following year. Just note that you will have to take two RMDs that following calendar year, one by April 1st, and the other by December 31st.
I have some clients who wait until December to pull their RMD if they don’t have a need for the cash flow. This way they can maximize their tax deferral and keep their funds invested as long as possible before taking the RMD. On the other hand, if you have a need for the income to meet your expenses, you might opt to take an equal monthly installment to reduce the risk of selling out at the wrong time. It also helps create a steady cash flow stream for budgeting purposes in retirement.
Qualified Charitable Distribution
A Qualified Charitable Distribution, also known as QCD, allows for you to donate up to $100,000 of your IRA directly to a qualified 501c3 charitable organization. The Protecting Americans from Tax Hikes (PATH) Act of 2015 has made the QCD a permanent part of the IRS code and allows you to count that distribution towards your RMD that year, but exclude it from your adjusted gross income! The QCD must come from an IRA (traditional IRA, inherited IRA, or an inactive SEP or inactive SIMPLE IRA), it cannot come from another qualified plan like a 401k or 403b plan. Of course, the account must also be in the RMD phase.
Example. If your RMD is $100,000, normally you would be required to withdrawal $100,000 from the balance of your IRA and include the distribution in your gross income. However, you could instead elect to donate up to $100,000 to a charity, or multiple charities, directly from your IRA and reduce your taxable income by up to $100,000. Of course, the charity also receives that donation tax free as well. This results in a significant amount of tax savings for the IRA owner and provides a larger donation to the charity of your choosing. Also note that the $100,000 limit is annually per person. If you are married, you would each have that $100,000 limit if you both qualify for a QCD.
This has become increasingly more beneficial with the Tax Cuts and Jobs Act signed into law in 2017 (TCJA). The TCJA doubled the standard deduction which for 2021 is $12,550 for single tax payers and $25,100 for married couples filing jointly. The new law significantly reduced the number of tax payers who itemize their deductions. Charitable donations are an itemized deduction, so if a tax payer is not itemizing their deductions, the charitable donation has zero tax impact to the tax payer. Therefore, the QCD allows for the tax payer to essentially get a tax benefit for donating to charity without needing to itemize their deductions. Excluding the donation from your adjusted gross income could have other tax advantages as it might reduce your Medicare premiums as well as your overall tax bracket.
It’s important to note that the charity has to be a qualified 501c3 organization. You cannot donate to a private foundation or a Donor Advised Fund. However, there is no limit on the number of organizations you donate your QCD to. Most financial institutions allow you to create a list of the organizations that you want to benefit from your donation, and they will send the checks for you directly from the IRA.
Many clients I serve run into what I call the tax trap of traditional IRAs and 401ks. I wrote an article about this and you can read more about it here. The gist is they are the victim of their own success. They saved and invested wisely, and accumulated a bulk of their assets in tax deferred vehicles, among other assets. At RMD age, they are forced to take distributions they may not need, thus creating a negative tax effect (higher tax brackets, higher Medicare premiums, increased social security taxes etc.). QCDs can certainly help alleviate that tax burden for those that are charitably minded. However, you still want to do some planning well before turning 72 to optimize your tax situation. If you plan to donate to charity during retirement, make sure you leave some room in your tax deferred plans to make those QCDs. On the other hand, make sure your RMD’s wont push you into higher than anticipated tax brackets or bump your Medicare premiums up substantially. You may want to consider doing some Roth conversions, or leveraging a Roth 401k option in lieu of a Traditional 401k. The point is, don’t be blindsided by RMD’s, but be intentional well before you begin taking those distributions so you don’t run into the tax trap!
Qualified charities do not pay taxes on distributions. I mentioned the SECURE Act briefly and also wrote about it in more detail in the article I referenced earlier (link here). The important thing to note is that it eliminated the inherited IRA for most non spousal beneficiaries. Therefore, when you leave those 401ks or IRAs to your children, they will be forced to liquidate all of the funds within 10 years, accelerating taxes on those plans relative to the previous law. This is a further validation for not only QCDs for charitable giving during lifetime, but also for naming those charities as a beneficiary for these tax deferred accounts. Instead of leaving those assets to your children for your legacy goals, you may consider leaving other assets such as life insurance, Roth accounts, or taxable brokerage accounts that are more tax advantageous for those beneficiaries. Again, thoughtful planning is critical to provide these opportunities before it’s too late to make any meaningful changes.
Donor Advised Funds
A Donor Advised Fund, or DAF, is an opportunity for individuals to donate cash or securities to these specified accounts, potentially recognize a tax deduction, and allow the funds to grow tax free to be used in the future for charitable giving. Unlike donating to a specific charity outright, the DAF can benefit as many charities as the donor chooses. Additionally, I’ve seen clients name their children as successor Donor Advisors in order to teach the next generation how to be a good steward of their dollars. A big advantage of a DAF is the ability to front load donations. As I mentioned earlier, many tax payers are taking the standard deduction given they don’t have itemized deductions that exceed the standard deduction amounts. However, if you plan to donate each year for the next several years to certain charities, you might consider front loading a contribution to a DAF in order to qualify for an itemized deduction, and then spread out the actual donations over several years. Let’s look at an example.
Brenda is married and normally donates $5k/year to a local animal rescue. The $5k donation, along with other deductions, does not exceed $25,100 (standard deduction for married filing jointly). Therefore, that $5k donation is meaningless from a tax standpoint. However, Brenda will continue to donate $5k for at least the next 10 years. She has cash savings in excess of $100,000, so she decides to donate $50k to a DAF ($5k x 10 years), which puts her over the standard deduction limit and gives her the ability to deduct that $50k donation! Going forward, she will make a distribution from the DAF in the amount of $5k/year over the next 10 years to benefit the charity! Additionally, she can choose to invest the dollars in the Donor Advised Fund, so she has the possibility of growing her account balance even more for her charitable goals.
The DAF also allows for contributions from appreciated assets, like stocks, bonds or mutual funds. Let’s say you owned a stock that appreciated $100k over the original value. This is obviously great news, but if you sold the stock, you would include that $100k in your adjusted gross income and would owe taxes. However, if there is no need for that particular security for your retirement or other financial goals, you could donate that security to the DAF without any tax consequences. Additionally, the DAF could sell the security and reinvest it into a more diversified portfolio without incurring any taxes either. This is a powerful tool to utilize for those appreciated securities that don’t have a specific purpose for your own income needs.
It’s very important to note that a DAF contribution is irrevocable. Donors cannot access those funds except when used for donations to a qualified charity. However, there is no time limit on when the funds need to be distributed. Just like any charitable contribution, make sure it aligns with your financial goals and is coordinated with the rest of your financial picture.
If you plan to make financial gifts to charitable organizations, make sure you consult with your tax advisor, estate attorney and of course your financial planner. Make sure your charitable giving is coordinated with your overall plan, and also make sure you take advantage of tax benefits where possible. There are certainly more ways than a QCD and DAF to satisfy charitable goals, so please be sure that you choose the right solution based on your unique circumstances. If you would like to discuss your charitable giving strategy, or other financial goals, you can always start by scheduling a no obligation “Mutual Fit” meeting below to learn how to work with us. We look forward to speaking with you!