QUALIFIED CHARITABLE DISTRIBUTIONS
Today I want to talk about a loophole in the tax code. A big, juicy, wide-open loophole. A loophole so big, most people will never actually be able to use the whole thing. Yet sadly, a loophole that is so unknown, many readers will have never heard of it. What’s worse though, is that the tax preparers of many readers haven’t heard of it either.
To call it a loophole, might not be the best description. Because, quite honestly, the IRS knows it is there, and they have left in there for a reason. It does not require any backdoor trickery, or any number fudging. It doesn’t even live in the gray area; it is completely black and white.
I am talking today of the qualified charitable distribution, or QCD for short.
What are RMDs
To start we need to back up. There is a prerequisite we need to understand before we can dive into QCDs and how they work. We need to talk about another acronym, the RMD. RMD stands for required minimum distribution. It relates to any qualified pre-tax retirement account like an IRA, 401K, Simple IRA, SEP IRA, and a few others. To make a long story short, any money that you have saved into one of those accounts is what the IRS calls pre-tax. It’s pretty self-explanatory, but it means that you have never paid income tax on the balance in the account. You pay the taxes on withdrawals from the account, presumably once you are retired and no longer earning an income. Some investors never end up really needing that money, so they delay taking withdrawals. Believe it or not, there will come a day when the governments patience will run out, and they will require you to start withdrawing money from that account so they can begin to collect taxes. While the amount is not enormous, there will be a MINIMUM amount you are REQUIRED to have DISTRIBUTED from your account every year. See where the acronym comes from there?
In theory, the IRS can’t MAKE you take these withdrawals. You could test your luck and just leave the money in your retirement accounts. If you never get audited, there is a chance you may get away with it. However, if you get caught, the IRS will impose a penalty that is equal to half of the amount you should have taken out, plus interest. I would not recommend testing your luck here. Or anywhere for that matter.
Ways to Avoid RMDs
Short of just not doing it, there are a couple of ways you can avoid having to take these required withdrawals, or at least avoid having to pay taxes on them. The first method is to begin the process of converting your traditional IRA/401k into a Roth IRA. Doing this strategically can greatly reduce the overall amount of taxes you will have to pay over your lifetime, and if you convert everything, you can avoid RMDs, as Roth IRAs are not subject to required withdrawals at any age.
If you weren’t able to get everything converted by the time you turn 72, there is some relief. While there is no way to avoid having to take the withdrawals at this point, there is a way to avoid paying taxes on them. That method is what this article is about. The qualified charitable distribution.
What is a QCD
To start, QCDs are not nearly as complicated as you may initially think. I know often times anything involving the IRS can seem somewhat scary, and confusing, but I promise, there is not a lot to this one as far as forms to fill out and hoops to jump through.
A Qualified Charitable Distribution is an item in the tax code that allows an individual over age 70 to make distributions from their qualified retirement accounts (IRA 401k etc.) directly to a charitable institution and claim that amount as a deduction on their taxes ABOVE the standard deduction. What can make these even more powerful, is that the amount of a QCD is NOT limited to the amount of your RMD. You are in fact able to make a QCD of up to $100,000 per year, per individual. We will dive more into the tax savings in a moment, but first let’s go over a couple of key consideration when making a QCD, to make sure your distribution will qualify.
first, the distribution needs to be made payable directly to a charitable organization. That means generally an electronic payment is sent directly to a charity, or a check is sent out from your IRA made out directly to the charity. The only requirement the IRS sets on who qualifies as a charity, is the 501c3 designation. If that designation means nothing to you can take it to mean, just about any nonprofit group will qualify. That can range from your church to a public university, and everything in between. As long as the payment is made directly to one of those organization, you have fulfilled the requirement.
The second distinction is not a requirement, but simply a recommendation. That is that when you request the distribution, you also request to have ZERO taxes withheld from the payment. If you forget this step, it can be fixed later, but doing it this way will make your life much easier when you file your taxes. The reason I recommend not having any taxes withheld relates to how the IRS treats QCDs and how they can help you reduce your tax bill.
Why Do They Matter Now More Than Ever?
The reason not a lot of people know about QCDs is because prior to the Tax Cuts and Jobs Act, they would have done anything to lower most peoples tax bill. Prior to that act, when the standard deduction was much lower, the majority of individuals over age 700 were already itemizing their deductions, and by doing so, they were already claiming a deduction for their charitable giving.
Once the Tax Cuts and Jobs Act kicked in, the vast majority of Americans started claiming the standard deduction, as their itemized deductions were less than this amount. That meant that the charitable contributions they were deducting before, were no longer doing anything to lower their tax bill. Enter the QCD and the reason for why it matters now more than ever.
To make this stick I like to use examples. So, let’s use a hypothetical couple called the Johnson’s. They are both 78 years old, and prior to the Tax Cuts and Jobs Act, they were always itemizing their deductions. They usually give about $10,000 to their church, $4,000 to other charitable causes, and have a few thousand in medical expenses. In total, they used to average about $22,000 in deductions so itemizing made sense for them.
Once the Tax Cuts and Jobs Act kicked in, they found that itemizing their deductions no longer helped them, because the standard deduction of $24,000 lowers their tax bill more than their itemized deductions would. So, since that act took place, they have been claiming the standard deduction of $24,000 per year for a couple.
Even though that act stopped them from claiming their donations to their church as a write off, they still continued to make them every year. So, they were still donating $10,000, and they were deducting $24,000.
If the Johnsons were to start using a QCD here is what could happen. Rather than writing a check out of their bank account to their church, they send a $10,000 distribution directly from their 401k, and choose to have no taxes withheld. The church still receives the same $10,000 that they always have, but now when the Johnsons file their taxes it looks a little different. They still claim the standard deduction of $24,000, but now, by using the QCD they are able to add that $10,000 charitable contribution ON TOP of their standard deductions making their total deductions $34,000. If the Johnson’s are in the 22% tax bracket, that move just saved them $2,200, and all they had to do was send it from a different account.
QCD on Steroids
That prior example shows how effective the QCD can be just in the course of normal life. Now let’s look at how powerful it can be as a tax planning tool.
What you didn’t know about the Johnsons, is they did a great job of saving. Between the two of them they have about $2,000,000 in 401k and IRA accounts. The Johnsons are also very devout in their faith and are committed the concept of tithing. Meaning they fully intend to give 10% of those accounts to their church.
Here is where the QCD goes from being a neat little planning tool, to a game changer. The 10% of $2,000,000 that they intend to donate comes out to $200,000. The QCD allows for each of them to donate up to $100,000 per year. So, what if they both donated $100,000 this year. They could take a total deduction of $200,000.
Since they have such a huge deduction, what if they made a corresponding move, and converted another $200,000 of their account into Roth IRAs, tax free, because they have an equivalent deduction. That would do a few things.
First, if they live an average life expectancy, that $200,000 Roth IRA will grow to around $500,000, and it will pass on to their kids TAX FREE. That alone will save in the neighborhood of $150,000 in income tax.
Second, by reducing the value of their Taxable retirement account by $400,000, the amount of their subsequent RMDs will be lower, which will in turn lower their amount of taxable income.
Third, since all of that money has now been tithed, they can now either continue to donate to their church if they choose, or they can use those funds to travel, fund college for grandchildren, donate to other causes, etc.
Fourth, their church got an upfront infusion of $200,000 in cash. If they attend a church like most small community churches, that money could go a LONG way in paying down debt, or funding building expansions and renovations etc.
Obviously, the numbers in the extreme case represent using the QCD to its absolute fullest. Not everyone will be able to, or even want to do that. But even in the regular case, when $2,200 was saved, the impact is fairly substantial. If you are over 70, and you give to charity regularly, or if you have a parent or friend who fits that category, they could be leaving a good amount of money on the table if they are not using this strategy.
If your accountant has never brought this up, you may need to find a new accountant. If your financial advisor has never brought this up, you may need a new financial advisor. You will be hard pressed to find a simpler way to reduce your retirement tax bill. At Balanced Capital we place a huge emphasis on tax planning, as we are believers that you should pay the IRS every cent that you are obligated to, but please don’t leave them a tip.