Making donations to charitable organizations – particularly at year-end – is an annual tradition for many Americans. Some consider it an essential part of the holiday season; to give back.
While this behavior on the whole is decidedly a good thing, the fact that it can be characterized as automatic for so many of us actually has one drawback: we very rarely think outside the box when it comes to the best way to facilitate our donations. We simply go through the usually year-end motions. As a result, some Americans are missing a key gifting strategy that can help their money go even farther.
The IRS has carved out a way for individuals who are over 70.5 make charitable donations up to a certain amount that are completely tax exempt. This is defined as a Qualified Charitable Distribution (QCD). If you practice charitable giving and are over age 70.5, this is definitely a tool you should learn about!
Tax exempt donations
First, we must reiterate that the QCD tool can only be used for individuals over 70.5. Even if you are turning 70.5 in a given calendar year, you’ll therefore need to wait until after your birthday before any of your donations will qualify – so plan your gifts accordingly!
Whereas a typical IRA withdrawal will count toward the individual’s taxable income for the year, the beauty of a QCD is that it is exempt from taxes all together.
Consider, for example, Jim, who is 73 and donates $5,000 to his local homeless shelter every December when the organization runs a donor-backed gift matching program. Jim typically writes a check from his bank account for the donation, but by instead sending the money as a check distribution from his IRA made payable directly to the homeless shelter, he’s able to utilize money that otherwise would have been 100% taxable to make a 100% tax free donation!
You can easily see how this strategy, applied over many donations over consecutive years, can result in great tax savings for Jim, and potentially give him even additional flexibility to give more as a result.
This gifting strategy is even more important now that nearly 90% of Americans take the standard deduction on their taxes and therefore don’t receive any tax deduction for their giving.
How does it work?
There are caveats when it comes to QCDs, and the rules must be followed exactly in order for your donations to qualify. So be sure to mind the fine print!
Only certain account types qualify
The IRS states QCDs can only be processed from the following account types: Traditional IRAs, inherited IRAs, inactive Simplified Employee Pension (SEP) plans and inactive Savings Incentive Match Plan for Employees (SIMPLE) IRAs. (Inactive SEP and SIMPLE IRAs are accounts that no longer receive employer contributions.)
The donation must be sent directly to a qualified organization
In order for a given distribution to meet the definition of a QCD, the funds must be payable to a qualified charitable organization, as defined in the tax code. If the organization is not legally registered as such, your donation cannot be counted as a QCD.
Furthermore, the account distribution must be made payable directly to the organization. For example, sending funds from the investment account to your bank account, and then writing a check to the charity, will not qualify.
QCDs are limited to $100,000 per person per year
Another wonderful thing about QCDs is that you are not limited to just one transaction. You can process as many separate donations as you like, thereby spreading the benefits of this tax planning tool to multiple organizations if you so choose. However, the IRS does cap QCDs at $100,000 per individual per year. Anything donated over that amount, even if split between separate investment accounts, will not be considered tax exempt.
Record keeping is key
The regular rules for substantiating your charitable donations must still be followed. That includes maintaining an account statement or written communication from the charity showing the organization name, the date of the donation, and the amount.
For any donation over $250, however, the record keeping requirement is heightened. At that point, you must retain written confirmation from the organization that also confirms whether any goods or services were provided in consideration of the contribution.
The check-writing option
Some IRA custodians offer check-writing as a tool for account owners to use and it is well worth the time to inquire about this, especially for charitably inclined individuals who enjoy spreading donations across multiple charities.
Instead of filling out a form or calling the account custodian every time you’d like to process a donation, check-writing gives you the ability to literally write the check yourself. You’ll need to make sure you have enough money available in the cash portion of your account to cover the full value of the check before writing it, but for those who track their accounts closely, this shouldn’t be a problem.
Tax reporting essentials
Come tax season, the 1099-R your account custodian issues will not distinguish between your QCDs and your other distributions. The burden therefore falls to you to make sure this gets reported properly on your taxes. However, there is a space provided on your return to indicate the taxable amount of your IRA distributions versus the total sum of all distributions.
QCDs & RMDs
The value of the QCD compounds all the more once an individual has turned 72 and is subject to Required Minimum Distributions (RMDs). The RMD is an IRS mandate requiring the owners of certain types of accounts – including IRAs – to withdraw a certain dollar amount per calendar year.For account owners who do not need to take the RMD as income, and who would be making charitable donations regardless, utilizing the QCD is a great way to hit two birds with one stone. They can both fulfill their RMD and reduce their tax bill by sending their donation sum directly from their investment account.
QCDs are an incredibly valuable tool for account owners over the age of 70.5, but they are unfortunately overlooked as a gifting strategy all too often. In many cases, this is simply due to lack of information; either being unaware of the tool itself, or being unsure of the various guidelines and caveats around it. However, with just a little effort and record keeping, you can take advantage of the QCD rule to maximize your charitable efforts, and reap the tax benefits it provides.