Posted on January 23, 2011 by

IRA Charitable Rollover is Back

There’s good news if you’ve reached age 70 1/2, and you have an IRA and philanthropic inclinations. Through 2011, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 resurrected the opportunity to make cash donations to IRS-approved charities directly out of your IRA.

Such qualified charitable distributions are federal-income-tax-free, but you get no itemized charitable deduction on Form 1040. But that’s okay. The tax-free treatment of qualified charitable distributions equates to an immediate 100 percent deduction, since the otherwise-taxable IRA dollars are sent directly to charity.

Who Benefits Most
From this Strategy?

The qualified charitable distribution opportunity is beneficial for taxpayers who:

1. Have reached age 70 1/2.

2. Make charitable donations, but don’t itemize deductions. (Under the normal rules, only itemizers get tax-saving benefits from charitable gifts).

3. Make large charitable donations, but their deductions would be delayed by the 50 percent-of-AGI limitation.

4. Want to avoid being taxed on required minimum distributions that they are forced to take from IRAs.

5. Are looking for a quick and easy estate-tax-reduction strategy.

Here is a detailed explanation of the qualified charitable distribution privilege, which was extended in the latest tax law.

The Basics

A qualified charitable distribution is a payment of an otherwise taxable amount out of a traditional or Roth IRA directly to an IRS-approved public charity. No more than $100,000 can be donated during any one year. However, if both you and your spouse have IRAs set up in your respective names, each of you is entitled to a separate $100,000 limitation.

As things currently stand, the ability to take advantage of this strategy is scheduled to expire at the end of 2011, but Congress may extend it again.

Income Tax Advantages

Qualified charitable distributions are not included in your adjusted gross income (AGI). This lowers the odds that you’ll be affected by unfavorable AGI-based provisions — such as the rule that can cause more of your Social Security benefits to be taxed and the rules that can reduce or eliminate deductions for medical expenses and passive losses from rental real estate.

In addition, you don’t have to worry about the 50 percent-of-AGI limitation that can delay itemized deductions for garden-variety charitable donations of cash.

Finally, a qualified charitable distribution from a traditional IRA counts as a payout for purposes of the IRA required minimum distribution rules. Therefore, you can arrange to donate all or part of your 2011 required minimum distribution amount (up to the $100,000 limit) that you would otherwise be forced to receive and pay income taxes on. In effect, you can replace taxable required minimum distributions with tax-free qualified charitable distributions that go to your favorite charities.

Special Rule for Distributions Taken in January of 2011

The new tax law retroactively restored the qualified charitable distribution privilege for 2010. However, because this happened so late last year (December 17, 2010 to be exact), the law included a favorable transition rule. Under that rule, you have until January 31, 2011 to take advantage of the qualified charitable distribution deal for the 2010 tax year.

Specifically, you can make an election with your 2010 tax return to treat qualified charitable distributions taken during January of 2011 as if they were taken in 2010 (up to the $100,000 limit for 2010). These amounts will also count as 2010 required minimum distributions (to the extent you have not yet taken them for 2010). Any other qualified charitable distributions taken during 2011 will count for this year (up to the $100,000 limit for 2011) and will also count as required minimum distributions from your IRAs (up to the 2011 amount).

Strategy: If you’ve not already taken all your 2010 required minimum distributions from your IRAs, you can arrange for qualified charitable distributions to be paid out by January 31, 2011 and treat them as 2010 required minimum distributions you may have remaining. That way, you can substitute tax-free qualified charitable distributions for taxable required minimum distributions. Frankly, not too many people are in position to do this, but you may be among the few who can.

How Distributions Affect IRA Balances and Your Estate

If you own one or more traditional IRAs to which you’ve made some nondeductible contributions, part of your IRA balances are taxable amounts (from your deductible contributions and account earnings) and part are nontaxable (from your nondeductible contributions). In this situation, qualified charitable distributions are treated as coming from the taxable amounts first. Being allowed to pull out taxable amounts first works to your advantage. Why? Because it allows you to completely avoid taxes on otherwise taxable amounts that are distributed from IRAs to charity, while leaving nontaxable amounts in the accounts that you can withdraw tax-free later on.

Last but not least, qualified charitable distributions reduce your taxable estate.

Example: Let’s say you’re 72-years-old and financially comfortable. You have $170,000 in one traditional IRA number one, and $140,000 in another traditional IRA, for a combined total of $310,000. You’ve made a total of $35,000 in nondeductible contributions to the two accounts. The remaining $275,000 is from deductible contributions and account earnings.

Before the end of 2011, you decide to take advantage of the qualified charitable distribution privilege by donating $100,000 out of the first IRA  (leaving a balance of $70,000 in that account).

The charitable distribution is treated as coming out of the taxable portion of your IRAs. So after the distribution, your IRA balances total $210,000 ($70,000 in the first account and $140,000 in the second). Of that $210,000, $175,000 is taxable money (the original $275,000 minus the $100,000 donated to charity), and $35,000 is nontaxable money (the entire amount of your nondeductible pay-ins).

The $100,000 qualified charitable distribution is more than enough to fulfill your 2011 required minimum distributions for the IRAs, but you owe no federal income tax. Here are the additional benefits:

  • Your required minimum distributions for future years have been substantially reduced. Reason: Your IRA balances have been reduced by $100,000. This equates to an immediate 100 percent write-off for the $100,000 gift to charity.
  • You still have the entire $35,000 of nontaxable money in your IRAs, which you or your heirs can withdraw tax-free later on.
  • You’ve lowered your taxable estate by $100,000.

Using Roth IRAs May Be Inadvisable

The idea of taking qualified charitable distributions out of Roth IRAs is not nearly as attractive as taking them from traditional IRAs. Reason: You and your heirs can take federal-income-tax-free Roth IRA withdrawals after the account has been open for at least five years. Also, your Roth IRA is not subject to the required minimum distribution rules until after you die. Finally, you’re allowed to withdraw the cumulative amount of your Roth IRA contributions at any time free of any federal income tax or penalty. For all these reasons, it is generally best to leave money in your Roth IRA for as long as possible rather than take money out with qualified charitable distributions. (The only obvious advantage to taking one from a Roth IRA is that it will reduce your taxable estate.)  

Mind These Caveats

Federal-income-tax-free treatment of qualified charitable distributions only applies when the entire amount that is distributed from your IRA would otherwise be fully deductible under the normal rules for itemized charitable donations (ignoring the 50 percent-of-AGI limitation). Therefore, if you receive any benefit from a charity that would reduce your deduction under the normal charitable donation rules, you will wind up with a taxable IRA distribution instead of the tax-free distribution you were expecting.

Finally, you cannot take advantage of the qualified charitable distribution privilege for payouts from a SEP account, a SIMPLE IRA, or any other tax-favored retirement account.

Conclusion: The charitable distribution strategy can be a tax-smart move for well-off senior taxpayers. However, check with your tax adviser before going forward. You want to make sure all the applicable tax rules are carefully followed.  

Source:  TrustCounsel’s January eNewsletter (BizActions).

Leave a Comment