Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I will occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis!) and my response, in the hopes that the discussion may be useful food for thought.

In this week's MailBag, we look at a recent inquiry regarding whether it's still a good deal to donate appreciated securities to a charity, now that the rules are back allowing Qualified Charitable Distributions (QCDs) directly from an IRA to a charity.



Question/Comment: With the new rules allowing you to donate money from an IRA to a charity, is it ever appropriate to donate stock anymore? Wouldn't not paying up to 39.6% on an IRA distribution be better than not paying 20% on capital gains given the new rates for 2013?

In terms of tax benefits, it is true that with the return of Qualified Charitable Distributions (QCDs) in 2013, it is a better deal to donate from an IRA than to just donate cash. Nonetheless, it's actually still inferior to donating appreciated securities.

The issue is that while a QCD avoids an ordinary income tax rate of up to 39.6%, a donation of appreciated securities also gives a tax deduction that avoids a tax up to 39.6%; however, donating the appreciated securities also avoids a long-term capital gains tax, too! 

An example may help to illustrate:

Client has $100,000 in three accounts: a checking account, an IRA, and some zero-basis securities. Assume a 20% tax rate on capital gains, 40% on ordinary income (makes the math easier, although technically a high income client would also face a 3.8% Medicare surtax as well). With respect to these three accounts, the client has a total net worth of $300,000, although some of it is pre-tax and some of it is after-tax.

- Scenario 1. If the client writes a check, that account is gone. The $100,000 donation by check gives a $100,000 charitable deduction, so if the client were to withdraw the IRA to spend it, the two would offset each other. In practice, the offset is never quite perfect; the income increases AGI and may impact certain phaseouts and credits, while the deduction may not be fully utilized in a single year and may have to be carried forward to a subsequent year. To account for the fact that the deduction may not perfectly offset the income, we can assume that the client ends out being able to spend about $98,000 of the IRA, losing the last $2,000 to the "tax slippage" of income and deductions. In the meantime, the client still has $100,000 of appreciated securities, which are worth $80,000 on an after-tax basis. The net result of this donation: the client's true after-tax net wealth remaining is $98,000 + $80,000 = $178,000 after doing a $100,000 donation.

- Scenario 2. Client does a $100,000 QCD from the IRA, eliminating the account entirely. The $100,000 in the checking account is all after-tax and can be spent anytime. The $100,000 of securities are still worth $80,000 after capital gains taxes. The net result: The client has $180,000 of after-tax wealth remaining after a $100,000 QCD, slightly better than Scenario 1, because there was no $2,000 "tax slippage" from trying to match above-the-line income and below-the-line charitable deductions.

- Scenario 3. Client donates appreciated securities. This produces a $100,000 charitable deduction, which can be applied against the $100,000 IRA, and with tax slippage once again the net value of the IRA would be about $98,000. The checking account is still worth $100,000 after tax. Net result: The Client donated $100,000 of appreciated securities, and has $198,000 of after-tax wealth remaining.

As the examples illustrate, in the end Scenario 3 wins by a healthy margin. In fact, the difference is attributable almost entirely to the capital gains taxes that were permanently avoided with the donation of appreciated securities, which applies in addition to the fact that there's a charitable deduction for the full fair market value of the stock. Certainly, the greatest caveat here is that the client needs to be able to use the charitable deduction over some reasonable time period; if donations are too high relative to income, the charitable deduction carryforward is lost after 5 years, and if deductions are too low and the client can't itemize the value is lost in the first place. And of course, in some cases the state tax treatment of charitable deductions can impact the outcome. But in the overwhelming majority of scenarios, the appreciated securities are the best outcome, and the results improve as either the capital gains tax rate or the magnitude of the capital gain increases. 

It's also worth noting that donating appreciated securities also has greater flexibility, as they can be used to fund split-interest trusts (e.g., a Charitable Remainder Trust {CRT} or Charitable Lead Trust {CLT}), private foundations, or donor-advised funds, while QCDs can only be done to public charities.

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  • Mike Rubin

    This analysis is very clear in its outcome based on the stated assuptions in a vacuum. However, some other factors must be weighed for many clients; first, many affluent clients in pay mode still have massive capital loss carryforwards. Second, this removes any step-up potential for long positions not necessarily ready to be harvested. And lastly and most importantly, clients with the wherewithall to take advantage of QCDs to the tune of 100,000 are likely clients for whom generational Roth IRA planning would make sense. I think that outside of this vacuum if you run the numbers a Roth conversion would significantly outperform any QCD that is beyond a client's RMD.

  • Anonymous

    Michael,
    Understood, but hear me out if you would. If the RMD is less than 100,000 you're reducing the retirement account more rapidly than required. Regardless, a Roth would remove future RMDs for the IRA owner and hence, enhance family wealth from a generational perspective. I find clients engaged in QCD planning are affluent taxpayers who would be receptive to Roth planning. If you have a 100,000 RMD you likely have a sizable IRA and net worth. There's my 2 cents, otherwise in a vacuum I agree with your thinking as laid out above.
    Mike

    • Michael Kitces

      Mike,
      I don't disagree with the value of Roth conversions. I've written about them extensively.

      In point of fact, what you're saying here supports what I wrote. Doing large QCDs is inferior to just donating appreciated securities, while donating appreciated securities also leaves the IRA available to be converted into a Roth (if that otherwise makes sense based on tax rates on other factors).
      - Michael

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  • JT in Tampa

    Michael,

    Great info again. I agree with you on your replies to the other posters. I am not sure why Roth conversions are even part of this particular conversation. The question was in regards to donating money to charity, not intra-family wealth transfer. The mere gifting of the appreciated assets was a pseudo-conversion of the IRA. Yes, is an actual conversion a smart thing to do after the donation, probably, but in the end, the question was specifically about which assets to donate, not tax plays for the next decade or two or three.

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  • Dave G

    Michael-

    You lost me here. Don't all of your scenarios assume that the #100,000 of appreciated securities have a basis of $0? You state that your assumption is that after paying 20 percent capital gains tax rate on $100,000 of appreciated securities that you will net $80,000. That would only happen if you had zero basis in the appreciated securities, which almost never happens.

    Am I missing something here?

    It also should be noted when you're donating appreciated securities you're limited to 30 percent of AGI if you're claiming the current value of the securities on Schedule A. Carryforwards apply as you state.

    Plus appreciated securities can be gifted to people with a lower effective capital gains tax rate. Heirs also get a step up in basis if you plan to leave the securities to them upon your death.

    Dave

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  • Corey Harper

    Michael,

    You made a passing reference to it, but it seems that the new Medicare surtaxes (as well as income/means testing for Medicare premiums) factor into this for higher income individuals. Depending on how much gain the appreciated securities have, reducing the surtaxes using a QCD seems like it could be the better deal in some instances.

    Corey

  • Michael Kitces

    Mike,
    I'm not sure I follow here.

    Doing a Roth conversion is unrelated to whether someone donates RMDs to charity via a QCD or not. They're separate matters and mutually exclusive (especially since RMDs are not even eligible for Roth conversion). In other words, whether you want to do a Roth conversion of your IRA funds in your later years can be done regardless of whether your RMDs go to a charity or not. The question is which dollars you send to a charity (QCDs or appreciated securities), not what you do with the money in your IRA that remains after RMDs.

    Respectfully,
    - Michael

  • Michael Kitces

    Dave,
    Yes, the assumption here is that the basis was $0, although you'll note that the math still works (albeit not quite as favorably) with a higher basis. Obviously, the greater the gains, the more value to donating the appreciated securities. But at almost any level of appreciation, getting pre-tax dollars to charity PLUS avoiding the gains (A + B) is still superior to just getting pre-tax dollars to the charity (only A).

    Yes, if gains can ultimately be avoided anyway with a step-up in basis or gifting to family members eligible for 0% capital gains rates, then it's a moot point, as there's no gain to avoid. The underlying assumption here, for better or worse, is that the client either expects the investment may change someday (such that gains will be recognized), and/or that the client someday intends to spend the money (which means it won't be held until death or gifted).

    Again, though, the fundamental point remains that if the gains will someday be paid, A + B (pre-tax plus avoiding gains) will still generally come out better than just A (pre-tax QCD to charity) if there's any substantive gains to avoid.

    I hope that helps to clarify the context a bit?

    Respectfully,
    - Michael

  • Michael Kitces

    Corey,
    It ends out helping both sides of the ledger as it were.

    If the income from the IRA is excluded (by doing a QCD), you may POTENTIALLY (but not always) reduce the 3.8% Medicare tax. After all, the Medicare tax doesn't apply to an IRA distribution itself. It only applies to other investment income. So this would only even potentially help if the client was right on the cusp where some investment income was over the AGI thresholds for the 3.8% Medicare tax, but the rest was not.

    However, by contrast, if the client is subject to the 3.8% Medicare surtax, ALL of the capital gains on the appreciated securities will be subject to it. As a result, if a QCD MIGHT be a Medicare surtax avoidance strategy, then donating appreciated securities would have to be as well, which just makes the appreciated securities version of the strategy even more valuable!

    Respectfully,
    - Michael

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