To take maximum advantage of this strategy for 2016, you'll need to replace some or all of this year's IRA required minimum distributions (RMDs) with tax-advantaged QCDs. Here are more details.
QCDs can be taken out of traditional IRAs, and they're exempt from federal income taxes. In contrast, other traditional IRA distributions are taxable (either wholly or partially depending on whether you've made any nondeductible contributions over the years).
Unlike regular charitable donations, QCDs can't be claimed as itemized deductions. That's OK, because the tax-free treatment of QCDs equates to a 100% deduction — because you'll never be taxed on those amounts. Additionally, you don't have to worry about any of the restrictions that apply to itemized charitable write-offs under the federal tax code.
A QCD must meet the following requirements:
- It must be distributed from an IRA.
- The distribution can't occur before the IRA owner or beneficiary reaches age 70 1/2.
- It must meet the IRS requirements for a 100% deductible charitable donation. If you receive any benefits that would be subtracted from a donation under the regular charitable deduction rules — such as free tickets to an event — the distribution can't be a QCD. This is an important pitfall to watch out for.
- It must be a distribution that would otherwise be taxable. A distribution from a Roth IRA can meet this requirement if it's not a qualified (meaning tax-free) distribution. However, making QCDs out of Roth IRAs is generally not advisable for reasons explained later.
Important note: You can also use the QCD strategy on an IRA inherited from the deceased original account owner if you've reached age 70 1/2.
There's a $100,000 limit on total QCDs for any one year. But if you and your spouse both have IRAs set up in your respective names, each of you is entitled to a separate $100,000 annual QCD limit, for a combined total of $200,000.
QCDs offer several potential tax-saving advantages:
- They're not included in your adjusted gross income (AGI). This lowers the odds that you'll be affected by various unfavorable AGI-based rules. For example, a higher AGI can cause more of your Social Security benefits to be taxed, less of your rental estate losses to be deductible and more of your investment income to be hit with the 3.8% net investment income tax. QCDs are also exempt from the rule that says your itemized charitable write-offs can't exceed 50% of your AGI. (Any itemized charitable deductions that are donations disallowed by the 50%-of-AGI limitation can be carried forward for up to five years.)
- They qualify as RMDs if they're taken from traditional IRAs. So, you can arrange to donate all or part of your 2016 RMDs (up to the $100,000 limit) that you would otherwise be forced to receive before year end and pay taxes on.
- They reduce your taxable estate, though this is less of an issue for most folks now that the federal estate tax exemption has been permanently increased. (The inflation-adjusted exemption for 2016 is $5.45 million.)
In addition, suppose you've made nondeductible contributions to one or more of your traditional IRAs over the years. If so, your IRA balances consist of a taxable layer (from deductible contributions and account earnings) and a nontaxable layer (from those nondeductible contributions). QCDs are treated as coming first from the taxable layer. Any nontaxable amounts remain in your accounts. In subsequent tax years, those nontaxable amounts can be withdrawn tax-free by you or your heirs.
QCDs from Roth IRAs
Should you make QCDs from Roth IRAs? Generally, the answer is no. That's because you (and your heirs) can withdraw funds from a Roth IRA without owing federal income taxes. The catch is that at least one of your Roth accounts must have been open for five years or more.
Also, for original account owners (as opposed to account beneficiaries), Roth IRAs aren't subject to the RMD rules until after you die. The bottom line: It's generally best to leave your Roth balances untouched rather than taking money out for QCDs, because the tax rules for Roth IRAs are so favorable.
The QCD strategy can be a smart tax move for high-net-worth individuals over 70 1/2 years old. If you're interested in this opportunity, don't wait until year end to act. Now is the time for mid-year tax planning, including arranging with your IRA trustee or custodian for QCDs to replace your 2016 RMDs.
Could QCDs Work for You?
High-net-worth senior citizens who can afford to donate money from their retirement accounts may benefit tax-wise from taking qualified charitable distributions (QCDs) if they match at least one of these profiles:
- You don't itemize deductions. Only people who itemize benefit tax-wise from regular charitable donations. Using QCDs provides a way for people who don't itemize to gain a tax benefit from making charitable donations.
- You itemize, but part of your charitable deduction would be phased out based on your adjusted gross income (AGI) or delayed by the 50%-of-AGI restriction.
- You want to avoid being taxed on required minimum distributions (RMDs) that you must take from your IRAs.