How to reduce your taxes and still donate to charity using a traditional IRA
The Tax Cut and Jobs Act (2017) made significant changes to the tax code, including nearly doubling the standard deduction for married couples over age 65 to $27,800 in 2021. This higher standard deduction decreased the tax advantages of some charitable donations that were traditionally given with after-tax dollars. To combat this, below we explore one way in which you can reduce your taxes and still donate to charity.
Qualified Charitable Distributions
Under the SECURE Act, if you are an individual age 70 ½ after January 1, 2020, you do not need to begin to take your Required Minimum Distributions (RMDs) from your traditional IRA until age 72. Prior to the Act, individuals had to start taking the RMD at age 70 ½.
Note that IRA distributions are taxable to an individual when they are paid to an individual.
For tax planning purposes, if you have some of your charitable donations made directly from your IRA rather than directly from your other funds, it will likely provide you a tax savings in 2021. This is referred to as a Qualified Charitable Distribution (QCD). With a QCD, you authorize your IRA custodian to make a distribution directly to a charity you select rather than to you. Further, the QCD is treated as part of your RMD for the year.
While the SECURE Act changed the age to begin taking an RMD, the Act did not change the age that you could begin using a QCD. The QCD is only available to those over age 70 ½.
Tax Treatment of a QCD: You do not include in your income the amount of the QCD paid to the charity. Further, you are not able to deduct this amount going to the charity. You will receive a year-end Form 1099-R for the total IRA distributions including QCD amounts. However, the taxable IRA amount on a return will be less than QCD amounts. Individuals are limited to $100,000 of QCDs in a year.
One other possible non-tax benefit with a QCD relates to individuals on Medicare. If you have higher income, the law requires an adjustment to your monthly premiums for Medicare Part B (medical insurance) and Medicare prescription drug coverage. Higher income beneficiaries pay higher premiums for Part B and prescription drug coverage. This affects less than 5% of people with Medicare, so most people do not pay a higher premium. If your adjusted gross income (AGI) is above $176,000 using married filing jointly, your Medicare premiums are increased. Depending on your situation, and since the amount of a QCD is not included in your AGI, use of a QCD might keep your Medicare premiums from being increased. Here is a link to the Social Security website that discusses this adjustment: https://www.ssa.gov/pubs/EN-05-10536.pdf (please note the SSA adjusts these thresholds and premiums each year).
Using this QCD approach, you direct your IRA custodian to send a check to your church or favorite not-for-profit as either a one-time donation or a monthly payment depending on your preference. At the end of year, you will receive a Form 1099-R for the full amount of your IRA distributions for the year, at which point you will need to let your CPA know what QCD amounts you made from your IRA. Your tax return then reflects the gross amount received, but the QCD is subtracted to arrive at the net taxable amount. You will also need a charitable acknowledgement of the QCD amount from the charity.
As you can see in our example, the same $20,000 amount was given to charity, but the overall taxable income by using the QCD alternative is lower by $17,800. This generates lower federal and state taxes. If your marginal tax rate is about 32%, you would save approximately $5,700 in this example (or, $320 for every $1,000 given to charity via the QCD).
This tax strategy is powerful and will allow those over the age of 72 to continue giving to charity while also reducing your overall tax. This may perhaps even allow you to leverage larger charitable contributions while staying within your budget.
Please consult your personal tax advisor to discuss the QCD options with your IRA.