As 2012 came to a close, many were focused on Congress and the uncertainty around tax laws, with a particular concern for the potential of higher income, capital gains and estate taxes. Overlooked by many was the tax-effective ability to use IRA funds for charitable gifting, permissible in 2012 (although Congress did not make us aware until January 1,2013) and extended through the end of 2013. Charitable gifting from an IRA utilizing required minimum distributions (RMDs), can be a beneficial strategy for a select group of taxpayers.
Background of Using IRAs to Fund Charitable Gifts
For individuals ages 70 ½ and older, the law requires that a certain amount—referred to as an RMD—be withdrawn annually from an IRA. The amount is calculated using an IRS formula derived by actuarial assumptions. An RMD from an IRA is treated as ordinary income and taxed at the recipient’s marginal income tax rate. If an individual were to gift funds from his or her IRA, up to a certain cap and following certain guidelines, the amount withdrawn for the gift would not be subject to income tax. Please note this strategy is not available for 401(k) plans or other employer sponsored retirement plans.
This strategy first took effect in 2006, however, it never became widely used because Congress hasn’t made it a permanent provision. As this tax break expired every few years, Congress would always find a way to reinstate it for another year or two. The strategy also lost some of its luster in 2009 when RMDs were suspended for the year due to economic depression.
The ability to gift from IRAs most recently expired at the end of 2011, however, in January of 2013, Congress agreed to extend the provision through the end of 2013. The rule allows an individual who is at least age 70 ½ to gift up to a maximum of $100,000 per year from his or her IRA directly to a qualified charity (a nonprofit organization that qualifies for tax-exempt status according to the U.S. Treasury). Gifting from an IRA can be used to fulfill charitable pledges, but it cannot be used to fund a charitable trust.
This distribution from the IRA is not recognized as taxable ordinary income on the individual’s tax return, therefore adjusted gross income (AGI) is not increased by the amount of the distribution from the IRA. This charitable gift is not recognized as an itemized deduction on a Schedule A tax form—listing it would be considered “double dipping” and not permissible by the IRS.
Who Should Use this Strategy?
Does gifting an RMD to a charitable organization always make sense? Not everyone should automatically assume all of their charitable gifts should be made from their IRAs. The ideal candidate for whom this strategy is most appropriate is someone who meets one or more of these criteria:
- Does not need the cash flow from his or her RMD to meet living expenses.
- Does not have highly appreciated securities in personal investment accounts.
- Charitable gifts exceed 30% of his or her AGI.
- He or she takes the standard deduction instead of itemizing; or itemized deductions are subject to phase-out.
- His or her AGI is above the new Medicare surtax limit subjecting investment income to an additional 3.8% tax.
The phase-out of itemized deductions has not been an issue for the prior three years, however, for 2013 (and beyond), this will be an important factor to consider when developing a charitable gifting plan. Certain itemized deductions (such as charitable gifts) will be reduced by 3% of AGI when income thresholds are crossed, but taxpayers cannot lose more than 80% of their deductions. Another consideration—new for 2013—is if a person’s AGI is above $250,000 (married, filing jointly) or $200,000 (filing single), gifting from an IRA provides another opportunity to help minimize exposure to the new Medicare surtax of 3.8%.
RMD Gifting vs. Cash Gifts vs. Appreciated Securities Gifting
When does it make sense to gift from an IRA? In general, an “above the line” deduction (one that reduces AGI) is better than a “below the line” deduction (e.g., an itemized deduction). However, if an individual does not meet any of the criteria mentioned above, gifting highly appreciated securities or cash may be more advantageous than gifting from an IRA. Consider the following examples:
RMD Gifting – Suppose someone is in the 25% marginal tax bracket with a $100,000 RMD and does not meet any of the criteria mentioned above. If the donor were to gift $25,000 of his or her RMD directly from an IRA, the donor’s AGI would decrease by $25,000; which equates to a $6,250 (25% x $25,000) savings in federal income taxes.
Cash Gifts – At the start of the year, suppose someone decides to take $25,000 of his or her RMD in a cash distribution and then gift it to a charity. Since the distribution was made in cash payable to the donor and not a check made payable from the custodian to the charity, that amount is not eligible to be deducted as a charitable gift from the person’s IRA. Therefore the $25,000 RMD amount will be recognized as a part of his or her AGI; however, it will still be seen as an itemized deduction, and could be subject to partial phase-out.
Appreciated Securities Gifting – Instead of gifting from an IRA or gifting cash, suppose a person decides to reduce the number of highly appreciated securities in his or her taxable investment account. If the person were to gift $25,000 of highly appreciated securities (with a cost basis of $5,000), his or her taxable income would be reduced by $25,000 (assuming the itemized deductions are not phased out); which equates to a $6,250 savings in federal income taxes. However, by removing the highly appreciated securities from the investment portfolio, the person would eventually avoid paying capital gains tax on the $20,000 gain and therefore save an additional $3,000 (15% x $20,000) in federal income taxes. If the person’s AGI is above $250,000 (filing single) or $300,000 (married, filing jointly) his or her itemized deductions may be subject to phase-out, which means not all of the $6,250 in tax savings will be realized by gifting highly appreciate securities.
Potential Candidates for IRA Gifting
- Taxpayers who are subject to the new Medicare surtax: High-income earners are now subject to the 3.8% Medicare tax. Reducing AGI can help avoid this excise tax.
- Taxpayers who are subject to the itemized deduction phase-out: High-income earners may not realize the complete tax savings of charitable contributions by gifting highly appreciated securities.
- Individuals who want to reduce taxes on their estates: IRAs are subject to income taxes as well as state and federal death taxes after the owner dies. Making qualified IRA gifts can help reduce these future taxes.
- Donors who cannot deduct all their contributions: The most a person can deduct for charitable gifts of cash in any year is 50% of AGI (although excess deductions can be carried over for up to five years). Gifts made directly from IRAs, however, are excluded from this 50% limitation, which makes possible extra tax benefits for individuals who wish to make large gifts in a particular year.
- IRA owners who wish to reduce future required minimum distribution: Large gifts from IRAs (maximum of $100,000) can shrink the size of the account and reduce the amount of required minimum distributions in future years, which have to be recalculated on an annual basis.
We have no certainty that the provision allowing for the direct gifting from an IRA will be extended beyond December 31, 2013. However, there are three months remaining in this year to discuss and plan for tax effective charitable gifting. We recommend that our clients discuss this with their financial advisors to determine if this is a suitable strategy.
Please remember, there are stringent requirements for properly executing a charitable gift from an IRA and the failure to properly follow those guidelines could result in the gift becoming taxable and therefore losing the tax efficiency desired.
An original article authored by the advisors of Wescott Financial Advisory Group LLC
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