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Act Now For Tax-Free IRA Withdrawals

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January 18, 2013 - 2013: Act Now for Tax-Free IRA Withdrawals - by Morningstar Investment Research

Retirees can donate their IRA distributions directly to charity and not owe income taxes on that amount, thanks to the American Taxpayer Relief Act of 2012, otherwise known as the tax deal to avert the fiscal cliff.

The new rules extend the qualified charitable distribution, or QCD, guidelines, in effect from 2006 through 2011, which allowed retired individuals age 70 1/2 or older to skirt income taxes on their IRA distributions by donating all or part of them, up to $100,000, directly to a qualified charity. The provision applies to the 2012 and 2013 tax years. Yes, that's right: The provision will apply to the 2012 tax year, too, even though the tax package wasn't enacted until 2013. There are two key ways for retirees to take advantage of the provision in order for it to affect their 2012 tax return, as laid out in this Internal Revenue Service bulletin. First, those who took their IRA withdrawals during the month of December 2012 can donate all or part of that amount to a qualified charity by February 2013. The amount of that donation, up to $100,000, will then be excluded from their 2012 adjusted gross incomes, or AGIs.

Alternatively, in January 2013, retirees can request that their IRA custodian transfer an amount equal to or less than $100,000 directly to a charity. Provided that maneuver is executed before Feb. 1, 2013, the retiree can then exclude that amount from his or her 2012 income. It doesn't matter whether the retiree has already taken required minimum distributions or other withdrawals from the IRA for the 2012 tax year; he or she can transfer additional amounts to charity to take advantage of the provision for 2012. (Those retirees who didn't take their 2012 RMDs by Dec. 31 can't, however, circumvent the 50% late RMD penalty simply by executing a QCD in January.)

For retirees who would like to avail themselves of the provision for the 2013 tax year, the rules are similar to what they have been in years past. Retirees must direct their IRA custodians to transfer the assets directly to the charity in order for the money to be excludible from their income in 2013. As with other IRA rollover types, it's important that the retiree never lays his or her hands on the money to avoid having that money count as taxable income. A retiree could take advantage of the QCD provision for both 2012 and 2013, provided the 2012 QCD action takes place sometime in January 2013.

Who It Can Help

The provision also allows retired investors to kill three birds with one stone: Not only can they make a charitable donation, but they can also reduce their AGIs and fulfill their RMD requirements. Even retirees who already took their RMDs in December 2012 can use their QCD to effectively negate the tax impact of those RMDs.

Despite those attractions, some investors are likely to greet the QCD provision with a shrug. After all, taxpayers can already deduct their contributions to qualified charities. But rolling assets from an IRA directly into a charity--rather than taking the IRA distribution, paying the taxes on it, and then making a deductible charitable contribution--can reduce AGI. And by keeping AGI down, taxpayers improve the odds that they'll be able to take advantage of various tax credits and deductions. Moreover, lowering AGI reduces a taxpayer's susceptibility to other taxes, such as the new Medicare surtax that's going into effect this year. (That tax affects the investment income of individuals with AGIs of $200,000 or more and married couples filing jointly with AGIs of $250,000 or more.)

As is probably already apparent, a QCD will be the most compelling for wealthy retirees who don't need their RMDs for living expenses, want to donate to charity, and would benefit from a reduction in their AGI. Moreover, those in a position to give a very high percentage of their incomes to charity might benefit from a QCD in an additional respect. That's because individuals can only deduct charitable contributions equal to 50% of their AGIs, provided they're giving money to what the IRS calls "50% limit organizations." (Individuals contributing to "30% limit organizations" can only deduct amounts equal to 30% of their AGIs.) The QCD maneuver enables such individuals--a rarefied lot, to be sure--to obtain a tax benefit by donating even more than 50% of their AGIs; they can obtain a deduction on 50% of their income, and reduce their AGI with QCD contributions above that limit. (Note that you can't obtain both a deduction and earn a QCD tax break with the same contribution, however--it's one or the other.)

But you don't need to be very wealthy for a QCD to make sense for you. If you're not itemizing your deductions, the QCD provides another way to derive a tax benefit from charitable contributions: Even though you're not able to deduct your charitable contributions, the QCD enables you to reduce your AGI.

Mind Those Details

As with an IRA conversion or rollover, it's critical to mind your ps and qs when executing a QCD. Make sure you're at least 70 1/2, that your charity qualifies under IRS guidelines, and that you obtain proper documentation of your contribution from the charity itself.

Finally, because the QCD touches a lot of different areas--including retirement planning, taxes, and estate planning--it's worthwhile to check with a tax advisor for guidance on whether this maneuver makes sense. As personal finance expert Michael Kitces argues in this blog post, many charitably minded investors might be better off gifting highly appreciated shares from their taxable accounts rather than employing a QCD.

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