As year-end and the holiday season approaches, charitable giving is once again on the minds of many individuals, and while supporting important causes is typically the primary driver of charitable giving, nearly all individuals want to make their gifts in the most tax efficient manner possible.
Last year we covered two tax efficient charitable giving strategies including gifting appreciated stock and bunching charitable deductions into a single year.
As giving season rolls around in 2023, we are revisiting the topic of tax advantaged charitable giving by considering qualified charitable distributions from traditional IRA accounts. Individuals who are eligible to make qualified charitable distributions (QCDs), will often find that QCDs are an extremely efficient way to make their charitable gifts and support the causes they are passionate about.
What are Qualified Charitable Distributions?
Qualified Charitable Distributions, or QCDs as they are otherwise known, are gifts made to charity directly from an individual’s traditional (pre-tax) IRA accounts. When QCDs are made directly to charities, the distribution is excluded from the taxpayer’s income (even if they don’t itemize their deductions) and can count toward their required minimum distributions (RMDs) to the extent their RMDs have not yet been fulfilled.
The maximum annual QCD amount is $100,000 per year for an individual. If a husband and wife both have IRA accounts and otherwise qualify to make QCDs, each spouse can contribute $100,000 from their own IRA for a total of $200,000 for the married couple in a given year.
To be eligible to make a qualified charitable distribution, the donor must be at least 70 ½ years old at the time of the gift. In the past, the age for QCDs and RMDs was the same (70 ½ years old); however in recent years as the RMD age has increased, the QCD age has remained the same.
In order to qualify as a QCD, the distribution must be made directly from the IRA to the charity. In practice, the individual typically submits a form to their IRA custodian, and the custodian then issues a check payable to the charity. In many cases the check is sent to the account owner for them to forward to the charity.
As long as the check is made payable to the charity, sending the check to the account owner is acceptable as clarified in IRS Notice 2007-7 Q&A-41. However, if the check is made payable to the account owner, it will not qualify for QCD treatment even if the funds are immediately donated to charity.
Since QCDs are excluded from income, taxpayers are not entitled to take a tax deduction for the QCD. In essence they already received a full tax deduction by excluding the income in the first place. Taxpayers are required to keep a written acknowledgement from the charitable organization to substantiate the gift in the same way that they would for a deductible gift to charity
Key Takeaway:
For individuals age 70 ½ or older with a traditional IRA, qualified charitable distributions are one of the most tax efficient ways to give to charity.
What Value Do Qualified Charitable Distributions Provide?
Why would an individual prefer a QCD over simply making a traditional gift directly to charity that would otherwise count as an itemized deduction on their tax return? To answer that question, we first need to revisit the difference between the standard deduction and itemized deductions.
As we covered in our blog post titled “Saving Taxes With Charitable Bunching,” individuals are entitled to take either the standard deduction or their itemized deductions when calculating their taxable income.
The standard deduction for a married couple who are both age 65 or older in 2023 is $30,700. The main itemized deductions include medical expenses over 7.5% of adjusted gross income, state and local taxes (max of $10,000), mortgage interest, and charitable contributions. Once all itemized deductions are added together, the taxpayer will choose the greater of their itemized deductions or the standard deduction when calculating their taxable income.
Most seniors do not have significant itemized deductions. Accordingly, any non QCD gifts to charity will typically provide little to no tax benefit since the gifts will not increase the taxpayer’s itemized deductions enough to reach the standard deduction they were already entitled to.
For example, assume a retired couple who are both over age 65 pay $4,000 annually in state and local taxes, have no mortgage, and have average medical expenses (which do not exceed 7.5% of their income). If they chose to give charitably, the first $26,700 of their charitable contributions would not increase their deductions at all. Those contributions would simply increase their itemized deductions to the level of their standard deduction as shown in the following graph.
In other words, most qualifying individuals who do not utilize QCDs will see that a large portion or potentially all of their charitable gift does not provide any tax benefit. For those individuals, it is much better to simply exclude the income from their tax return by using QCDs.
!!!Note!!! In the case of very large gifts that significantly exceed the standard deduction, appreciated stock may result in a larger tax benefit than QCDs. See discussion titled “Are Qualified Charitable Contributions Always The Best Option?” later in this article. Nevertheless, for gifts that will not significantly exceed the standard deduction, QCDs are typically the best option.
Key Takeaway:
Most retired individuals receive no tax benefit for cash gifts to charity because their annual giving is not substantial enough to exceed the standard deduction they are already entitled to receive.
To understand the value that QCDs can provide, let’s assume the married couple discussed above is in the 24% federal tax bracket and is also subject to a 6% state income tax bracket for a combined tax rate of 30%.
Besides their $4,000 in state and local taxes, they choose to give $25,000 annually to charity. Since the $25,000 given to charity plus the $4,000 in state and local taxes is less than their standard deduction of $30,700 (2023), they will continue to take the standard deduction and receive no tax benefit from their charitable gift.
Alternatively, if they chose to make the same $25,000 gift to charity from their pre-tax IRAs through QCDs, they would save $7,500 ($25,000 x 30%) in taxes since the income would be excluded from their tax return. As a result, choosing to give directly from their IRA would result in substantial tax savings.
Key Takeaway:
QCDs can provide a significant tax benefit for individuals who don’t already itemize their deductions.
What Are Other Benefits of QCDs?
Other benefits of qualified charitable distributions result from the fact that QCDs are entirely excluded from income. For example, adjusted gross income (AGI) represents a taxpayer’s income before any charitable deductions. AGI is an important concept because many tax benefits and phaseouts are based on AGI.
For example, Medicare’s Income Related Monthly Adjustment Amounts (IRMAAs), are based on a version of AGI. Additionally, many credits and deduction phaseouts are based on AGI as well as the net investment income tax (NIIT) threshold (i.e. the 3.8% Obamacare tax).
By using QCDs and keeping income completely off the tax return, taxpayers are able to keep AGI lower and more effectively avoid lost tax benefits that can result from reporting higher adjusted gross income.
Another benefit of QCDs is that they can help satisfy a taxpayer’s required minimum distribution. Individuals age 73 and older are required to take required minimum distributions (RMDs) from their traditional IRA accounts. Any amounts taken as QCDs will count toward the taxpayer’s RMD requirement in the year of the distribution as long as the RMD requirement has not already been satisfied by prior withdrawals during the year.
Key Takeaway:
Excluding income related to QCDs has the additional benefit of keeping AGI low which can impact numerous other tax items that are based on AGI such as Medicare premiums, the net investment income tax, and phaseouts for credits and deductions.
What Charities Qualify for Qualified Charitable Distributions?
To qualify for QCD treatment, the distribution must go to a qualifying charity. Qualifying charities include 501(c)(3) charities, but do NOT include the following charitable entities:
- Private Foundations,
- Supporting Organizations (charities that support other tax-exempt entities),
- Donor Advised Funds
Tax Reporting for Qualified Charitable Distributions:
Individuals who choose to make qualified charitable distributions will need to carefully report their QCDs at tax time. Custodians will issue 1099-R tax documents reporting the total distributions from pre-tax IRA accounts at year end.
The 1099-R forms will not differentiate whether a portion of the distribution was a QCD or not. Rather the 1099-R will show the entire distribution as taxable.
Accordingly, the taxpayer is responsible for adjusting the distribution on their own tax return to ensure the QCD portion of the distribution is shown as a non-taxable distribution. The taxpayer does this by adjusting the taxable portion of the distribution and including “QCD” as an explanation on Form 1040 to explain the difference between the total distribution and the taxable portion.
Key Takeaway:
The 1099-R received from the custodian at year end will not indicate a QCD. It is the taxpayer’s responsibility to ensure the QCD is excluded from taxable income.
Are Qualified Charitable Contributions Always The Best Option?
Taxpayers that otherwise qualify to make qualified charitable distributions should still consider whether a QCD is the most tax efficient approach for their charitable gift. QCDs are typically the most tax efficient approach when an individual’s charitable giving will not increase their itemized deductions to the point where they exceed the standard deduction.
However, individuals who are making large gifts to charity which will significantly exceed the standard deduction will often find that gifting appreciated stock may result in more tax benefit than a qualified charitable distribution. This occurs because a gift of appreciated stock can result in both an itemized tax deduction and the avoidance of capital gain. This double benefit can eclipse the benefit of a QCD if the gift is large enough.
As always, each individual should consider their own facts and circumstances and review all available options to ensure they identify the most tax efficient opportunity for charitable giving.
Key Takeaway:
Individuals planning to make large gifts should consider all their options before defaulting to QCDs – especially if the gift is large enough to significantly exceed the standard deduction.
Conclusion:
As year-end approaches and individuals begin considering their charitable giving goals for 2023, it is important to consider not just the charities to support, but also the most tax-efficient way to contribute.
For individuals who are over age 70 ½ and have pre-tax IRA balances, qualified charitable distributions may be the most tax efficient way to fulfill their charitable goals. Since QCDs are excluded from income, individuals are able to lower their taxable income and reduce their tax obligation – even without itemizing their deductions.
If you are interested in meeting with one of our Family CFOs to learn whether qualified charitable distributions could help you maximize the tax benefits associated with your charitable giving, we would love to connect to see if what we do is right for you.
