Congress has been in the habit of extending a variety of tax rules so late in the year that financial advisers barely have time to think about their impact before they expire again. However, the 2015 version of the extenders bill (The PATH Act) made permanent many of the expired provisions; so we now have time to dissect them to better understand their true value to taxpayers.
Let's take, for example, "qualified charitable distribution" (QCD), where taxpayers can make individual retirement account distributions payable directly to a qualified charity without treating the distribution as taxable income.
BASICS OF QCD
As in prior years, up to $100,000 per taxpayer can be contributed directly from an IRA to charity, and the distribution will count towards the owner's Required Minimum Distribution (RMD) for the year. In order to be considered a QCD, the following conditions must be met:
• The IRA account holder must be age 70½ or older as of the date of the distribution.
• The distribution must be made to public charities, not donor-advised funds or supporting organizations.
• The full payment to the charity would have to qualify as a charitable contribution.
• The distribution must be a direct transfer from the IRA trustee to the charity, not a reimbursement to the IRA owner for gifts they made previously on their own.
Without the QCD rules, a taxpayer would take a distribution from their IRA (which would then be included in their adjusted gross income), donate the same dollar amount to a charity, and offset the IRA income by claiming an itemized deduction for the donation. In many cases, the two amounts would offset each other, and the taxpayer's taxable income would be unaffected.
When a QCD is made from an IRA, however, the taxpayer neither reports the income as part of his/her AGI nor claims a charitable deduction. This treatment may seem to provide the same tax result as just donating the cash from the RMD, but it does offer some unique benefits:
• Excluding the IRA distribution from income lowers the taxpayer's AGI. This can help high-income taxpayers avoid the phaseout of itemized deductions and the 3.8% Medicare tax on investment income. It will also be easier to deduct expenses subject to AGI floors, such as medical or miscellaneous expenses.
• Some taxpayers don't get an immediate tax benefit for their donations — either because they claim the standard deduction rather than itemizing or their donations exceed the cap on charitable deductions. These taxpayers can use QCD to exclude an IRA withdrawal from income — the same benefit as deducting the donation.
While a QCD can provide a real tax benefit to some IRA owners, in most cases keeping the RMD and giving appreciated securities to charity will be a better tax strategy.
For example, assume a taxpayer is subject to a $30,000 RMD from their IRA and is considering giving that directly to charity as a QCD. They also own low-basis stock worth $30,000 that could be donated to charity in lieu of the QCD.
By transferring the RMD directly to a charity, the taxpayer still holds the appreciated stock with its looming tax liability. Instead, by keeping the RMD and donating the stock, the taxpayer avoids both the tax on the RMD and the capital gain on the stock. They now hold cash, which is more valuable than stock with an embedded tax cost, and if they still want to own the stock they can repurchase it with the cash from the IRA.
The greater the gain on the investment held by the taxpayer, the greater the tax benefit of donating that investment rather than donating the RMD and then selling the stock. This tax benefit would be lessened the longer the gain on the stock is deferred into the future. Holding the stock until death, and thereby receiving a basis adjustment, can also eliminate the capital gain. However, holding the cash from the RMD reduces portfolio volatility and provides flexibility for future investments.
Investment and tax advisers should collaborate to determine the best way for their clients to meet their charitable obligations. While the QCD may seem attractive at first glance, often it's not the best long-term strategy.
Tim Steffen, CPA/PFS, CFP®, CPWA®, is director of financial planning for Robert W. Baird & Co. Follow him on Twitter @TimSteffenCPA.