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The ABC's of QCD's: Qualified Charitable Distributions Explained

After having played political ping-pong with them for almost a decade, Congress finally made qualified charitable distributions (QCD's) a permanent feature of the tax code late in 2015.  And that's a good thing: (a) for those who consider their IRA required minimum distributions to be an unneeded and tax-inefficient nuisance, (b) for charitably-minded retirees, and (c) for charities in general.

What Are QCD's?

Qualified charitable distributions are made when an IRA owner, who has reached age 70 1/2, directs the account's custodian to distribute funds to a charity.  Aside from this age restriction, there are a few other administrative details to be aware of:

1. The distributions must come from traditional or rollover IRA's.  They cannot come from retirement plan accounts, e.g. 401k's and 403b's, nor from SEP or SIMPLE IRA's to which the owner is still in the process of making ongoing contributions.  (The distributions can technically come from Roth IRA's, but that would defeat the purpose.)

2. The recipients of the distributions must be qualifying public charities.  The recipients cannot be donor-advised funds or private foundations.

3. The funds distributed must go directly, or at least be payable directly, to the charity.  The IRA owner cannot take possession of these funds first, and then pass them on to the charity.  Nor can the IRA owner make the charitable contribution first and then request a distribution as a reimbursement.

In practice these administrative details pose few problems, and most IRA custodians can process QCD requests fairly smoothly by now.

The Payoff: Tax Benefits of QCD's

The payoff to making qualified charitable distributions comes in the form of tax savings.  Each IRA owner is permitted to make up to $100,000 worth of QCD's per year without any effect at all on their tax returns.

Now I realize that the prospect of giving away money, without having to pay taxes in the process, isn't going to make every retiree jump for joy.  But qualified charitable distributions can make a lot of sense for the seniors mentioned above (those whose RMD's are at least somewhat extraneous or those who are charitably-inclined anyway) when their alternatives are considered from a tax perspective:

For retirees who consider their IRA required minimum distributions to be an unneeded and tax-inefficient nuisance -

Taxpayers can only make qualified charitable distributions after they have reached age 70 1/2.  And of course it's no coincidence that attaining this age also triggers the need for IRA owners to start to take required minimum distributions.

To the extent that RMD's contain pre-tax dollars, these distributions are taxable as ordinary income and will boost adjusted gross income (AGI).  In turn, raising a taxpayer's AGI can have all sorts of negative financial repercussions including:

  •  bumping the taxpayer into a higher tax bracket, both for ordinary income and for capital gains;
  •  reducing tax exemptions, deductions and credits to which the taxpayer would otherwise be entitled;
  •  exposing the taxpayer to the 3.8% Medicare surtax on investment income;
  •  increasing the taxation of the taxpayer's Social Security benefits; and
  •  raising the taxpayer's Medicare premiums.

So for retirees who don't need all of their RMD's to make ends meet anyway, these distributions may add considerable insult to injury from a tax perspective.  The alternative then is to direct these distributions to charity via QCD's.

(As an aside, to read a couple of other articles about financial planning strategies to reduce or eliminate IRA required minimum distributions, please click on Should You Convert Your IRA or 401k to a Roth IRA? and Longevity Insurance: Coming Soon to a 401k Near You?). 

Qualified charitable distributions fulfill a retiree's obligation to take RMD's without any of these negative repercussions.  The question for these seniors then becomes (and especially when their state tax bills are also considered): "Would you rather be forced to take an amount out of your IRA and watch up to half of it go to government, or would you rather have the entire amount go to the charity of your choice?"

For retirees who are charitably-disposed anyway -

For these taxpayers, an alternative to arranging QCD's is to take their RMD's as usual and then write a check to charity.  It's then possible that the itemized deduction associated with this charitable contribution might fully offset the taxable income realized in the taking of the RMD.

However, for many seniors it makes more sense to take the standard deduction rather than to itemize deductions since their mortgages are often fully repaid by that point.  When this is the case, the donor won't receive the full tax benefit of their charitable contribution.  And even if they can take advantage of the full charitable tax deduction, the possible negative repercussions noted above of having a higher AGI still remain an issue.

To summarize, a qualified charitable distribution isn't necessarily the best way to give to charity, and of course it's not even an option until age 70 1/2.  But a QCD can be an attractive strategy compared to the alternatives, and given the right set of client circumstances and objectives.  It's merely another tool in the toolbox, and for that reason it's constructive to see this strategy become a permanent addition to the tax code.

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.  

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