With year-end tax planning underway, now is the perfect time to bring up a perennial tax trick; making a charitable donation directly from your IRA. This is known as a qualified charitable distribution.
Perhaps you’ve already received that annual letter from your favorite charity where it says you can support your cause while simultaneously satisfying your required minimum distribution from your IRA. Better yet, you can pull off this feat and lower your tax bill!
To begin to understand this pitch, we need to first quickly review what a required minimum distribution is and how it typically affects your tax bill.
When you reach the magical age of 70.5, the IRS expects you to start paying some taxes on your tax-deferred accounts. These include all of your IRAs, 401(k) accounts and any other accounts that were funded with pre-tax earnings.
For example, if you’ve saved $500,000 across all of your tax-deferred accounts, at age 70.5 the government expects you to distribute a minimum of close to $20,000 that very first year. It’s normally considered taxable income to you.
Now, when you make a donation to a qualified charity directly out of your IRA, the government says it’s okay to count it against your required minimum distribution and it’s also okay to not count it as taxable income. It’s as if the IRS officially turns a blind eye to the whole transaction. None of that IRA distribution has to be reported by you as income and, of course, no charitable deduction will be allowed by you either. It looks like a wash.
This begs the question, how can making the donation from your IRA be better than simply writing a normal check to your charity and taking the normal charitable deduction on your tax return? The short answer is, it may or may not. It depends on your tax situation.
There are two primary deductions on your tax return that are affected by your level of income, including IRA distribution income. They both reside on Schedule A, where you itemize your various deductible expenses.
First, you can deduct your out-of-pocket medical and dental expenses. However, only the amount that exceeds 10% of your income is deductible. Second, you can similarly deduct various miscellaneous expenses, such as the fees you pay your accountant and investment adviser. That deductible threshold is 2% of your income.
Naturally, if you make a donation directly from your IRA, being able to ignore that income on your tax return lowers those thresholds and allows an incrementally greater amount of your medical expenses and professional fees to qualify as deductible. Alas, you see a lower tax bill, however slight it might be.
But, what if your typical income is already so high – even before considering the income from your IRA distributions – that you aren’t allowed to deduct any of your medical expenses and professional fees anyway?
If this is your situation, going through the hassle of making a charitable donation directly from your IRA is no better than writing a check. If this is still confusing to you, just ask your investment adviser or tax preparer. Beware, they might charge you a fee, non-deductible, of course!