Tax time has come and gone. Even with the delayed tax deadline, I suspect procrastination was still the order of the day. Understandable? Yes. Costly? Maybe.
With my normal review of tax returns for clients, I spot an error every so often. But, I can tell you tax preparers do their best in the very limited time they’re given. Imagine having a client drop a pile of papers on your desk with their half-completed tax organizer sitting on top. From my vantage point, it’s not an easy job.
Now, imagine if the government adds to the complexity and confusion? Let me highlight one example.
When you reach 70 ½, you can start using your IRA as a tax-smart charitable tool. When you donate to charities out of your IRA, those distributions aren’t considered taxable income. This stands in stark contrast to IRA withdrawals that you use for your normal life expenses.
Remember, your IRA money has never been taxed. You were given a tax break when you contributed to your IRA. You then invested that money, possibly for decades, without paying any tax on the income you earned. When you do eventually withdraw money from your IRA, you finally have to pay tax on it. That is, except when you give money directly to charity. Those donated distributions don’t count as taxable income.
Even better, the amount you give to charity from your IRA helps to satisfy your required minimum distribution (RMD) for the year. In other words, what you give to charity from your IRA can help to lower your taxable income. Doesn’t that sound suspiciously similar to getting a charitable deduction? It certainly does and it’s a very nice tax break (for those age 70 ½ or older) who take the standard deduction and would otherwise lose out on deducting their charitable donations.
Unfortunately, things can and do go wrong with this tool.
Brokerage firms, such as Schwab, Fidelity and Vanguard, are tasked with sending out a tax report – called Form 1099-R – to both you and to the IRS. Form 1099-R lets everyone know how much you took out of your IRA. However, there is no breakdown of the amount you used for yourself and the money you gave to charity. Instead, they just report to the IRS the full amount that exited your IRA. The IRS doesn’t even require brokerage firms to remind everyone that some of your withdrawals possibly went to charities and, therefore, shouldn’t be considered taxable income.
Unwittingly, many taxpayers who wisely make charitable donations directly from their IRA may be paying tax on the money they’ve given to charities. So, if you only do one thing today, pull out your old tax returns to see if an amended tax return is in your future. Just when you thought tax season was over!