Why Qualified Charitable Distributions From IRAs Are Often Not Best For End Of Year Contributions

Posted by Michael Kitces on Wednesday, December 18th, 7:01 am, 2013 in Taxes

While charitable giving should always be done first and foremost for charitable and not tax purposes, the Internal Revenue Code does afford a number of different tax strategies for charitable giving. In recent years, the opportunity to complete "Qualified Charitable Distributions" (QCDs) directly from IRAs to a charity have been especially popular, in part because QCDs not only allow for "spending" amounts in IRAs without ever paying any taxes, but also because QCDs satisfy an individual's Required Minimum Distribution (RMD) obligations (and since QCDs are only available to those over age 70 1/2, there must be an RMD to satisfy!).

However, the reality is that while QCDs from IRAs do have favorable tax treatment, they are generally still less favorable than donating appreciated securities to satisfy charitable goals. While the former allows for entirely pre-tax charitable contributions (directly from an IRA), the latter effectively provides a "double tax" benefit, as contributions are deductible (making them pre-tax) and donations of appreciated securities permanently avoid taxes on the associated capital gains. As a result, while QCDs from an IRA are better to satisfy charitable goals than just writing a check or giving cash, using appreciated securities is still better (and the greater the appreciation, the more they come out ahead!).

Notwithstanding this difference in treatment, QCDs are still preferrable in situations where the deduction for donating appreciated securities might be limited - for instance, if the deductions in total will exceed the charitable contribution AGI limits (including the 5-year carryforward), where deductions have been already capped at 80% due to the Pease limitation, or for those who have so little in the way of itemized deductions that it would be better for them to simply claim the standard deduction (and donate separately via QCDs if desirable). And of course, sometimes the dollar amounts involved simply don't make it worthwhile to go through the hassle of donating appreciated securities. Thus, ultimately, whether QCDs or donating appreciated securities will be more tax-efficient depends upon the facts and circumstances of the situation; nonetheless, all else being equal, QCDs still tend not to be the best charitable giving option available!

The rules allowing Qualified Charitable Distributions (QCDs) from IRAs were first enacted as part of the Pension Protection Act of 2006, but were effective for only that year and 2007. At the end of 2007, the QCD rules lapsed, only to be reinstated retroactively for 2008 and into 2009 as an add-on to the Emergency Economic Stabilization Act of 2008 (the legislation that also created the Troubled Asset Relief Program {TARP}). At the end of 2009, the rules lapsed once again, and in the following year were reinstated retroactively once again for 2010 (and extended into 2011) as a part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the first "fiscal cliff" legislation). After 2011, the rules lapsed yet again, and most recently were reinstated again by the Taxpayer Relief Act of 2012 (the latest "fiscal cliff" legislation), once again bringing the rules back retroactively for 2012 (for which a special extension rule was necessary since the law wasn't even passed until January 2nd of 2013!) and extending them through the end of 2013, when they are scheduled yet again to lapse.

Given this varied on-again-off-again past, while the odds seem relatively good that QCDs will once again be extended - if not by the end of the year, then retroactively sometime in 2014 - under current law, clients have only a few more weeks to implement the strategy before it lapses once again.

Rules For QCDs

The requirements for completing QCDs are relatively straightforward: distributions must be made directly from an IRA to a charity (i.e., the distribution check is made payable directly to the charity), and must occur after the IRA owner has turned 70 1/2 (i.e., the IRA owner must actually be beyond 70 years and 6 months on the date of the QCD itself). Taxpayers are limited to up to $100,000 of qualified charitable distributions in a single tax year (though any distributions done in January of 2013 could have been applied against the 2012 tax year instead), though the limit is a per-IRA-owner limit (which means a husband and wife can each do $100,000, for a total of $200,000 as a couple, as long as each individually meets the requirements).

Properly completed QCDs in 2013 are excluded from income as an IRA distribution; no charitable deduction should be claimed for the amounts, as they are already a "perfect" pre-tax contribution by virtue of the fact that they came directly from an IRA. If the IRA has non-deductible contributions, QCDs are assumed to come directly from the pre-tax portion of the account (not from the after-tax amounts, and not on a pro-rata basis like other IRA distributions; see IRC Section 408(d)(8)(D)).

To the extent that the IRA owner also faces required minimum distributions (RMDs) - which must be the case, given that the owner must be over age 70 1/2 at the time - any QCDs will also satisfy the taxpayer's RMD obligations. However, it's worth noting that QCDs can only be done from an IRA, and only satisfy RMDs associated with IRAs (and not other types of retirement accounts like a 401(k) plan).

QCDs Compared To Other Charitable Alternatives

Given that QCDs provide a means to extra money on a pre-tax basis from an IRA - without ever facing taxation - and also satisfy RMDs (without triggering any income tax consequences), they have been a relatively popular strategy in recent years, especially for those who already were making charitable contributions anyway and faced an RMD regardless. While the individual theoretically could simply take the RMD and use the proceeds to make a charitable contribution by cash or check - with the deduction from the latter offsetting the income from the former - in practice they rarely offset perfectly, given that the RMD is "above-the-line" income when calculating AGI, while the charitable deduction is below-the-line and subject to various limitations). As a result, QCDs are virtually always at least slightly more tax-efficient than just donating by cash or check to offset the income from RMDs.

However, the reality is that while QCDs are more effective than simply donating by cash or check, they are still not as effective as donating appreciated securities. As discussed previously on this blog, donating appreciated securities essentially produces a "double" tax benefit - the full fair market value deduction nearly offsets the amount of any RMDs, and the individual permanently avoids the associated long-term capital gains liability. The greater the embedded gains in the investment being donated, the greater the tax leverage of using appreciated securities in lieu of QCDs. For instance, if a client in the 25% tax bracket has a $10,000 RMD and satisfies it with a $10,000 QCD, then $2,500 of taxes are permanently avoided. However, if the client takes the $10,000 RMD (triggering approximately $2,500 of taxes) and separately donates $10,000 of appreciated securities with a cost basis of $5,000, then the deduction produces roughly $2,500 of tax savings and the client permanently avoids what would have been a 15% x $5,000 = $750 long-term capital gains tax liability. The end result: the QCD saves $2,500 in taxes, but the donation of appreciated securities saves $3,250.

It's also notable that because QCDs must be made to certain types of public charities (so-called "50% charities") the options for charitable entities are more limited; if the client wishes to fund a donor-advised fund, a split-interest trust (e.g., a charitable remainder trust) or most forms of private foundations, then the donation must be done using appreciated securities (or cash or check outright), as a QCD would be ineligible for favorable tax treatment.

When QCDs Are Still Best

Notwithstanding the example above, the reality is that there are still some situations when QCDs are more favorable than donating appreciated securities after all.

The first is when the donation of appreciated securities will not be deductible due to the annual charitable contribution limitations (generally, 30% of AGI where appreciated securities are donated to a public charity); because QCDs are not treated as a charitable contribution (as they're directly excluded from income), the favorable QCD treatment is available even if the charitable contribution limits have otherwise been reached. Bear in mind, though, that excess charitable contributions are eligible for a carryforward for up to 5 years, so just because the deduction for donating appreciated securities cannot be used this year (due to the AGI limits) doesn't mean it won't be available. Nonetheless, in some situations charitable contributions are so high relative to income that the deduction cannot be used, even with carryforwards; in such situations, QCDs provide more favorable tax treatment (either in lieu of, or in addition to, further donating appreciated securities).

At the other end of the scale, if income is extremely high relative to deductions, the itemized deductions may be partially phased out as a result of the Pease limitation. As discussed previously on this blog, the mere presence of the Pease limitation should not be viewed as a disincentive against charitable giving, as it has no marginal effect on the value of a charitable deduction (including donating appreciated securities). However, if income is so high relative to deductions that they are being phased out all the way to the 80%-of-deductions cap, then the value of charitable deductions are in fact diminished (to about 20% of their normal value); as a result, while merely being subject to the Pease limitation should not dissuade using appreciated securities, those who have reached the Pease limitation cap should look to QCDs as a more favorable alternative.

For those with more limited itemized deductions, it's also worth noting that donating appreciated securities is also less favorable if the client doesn't itemize deductions in the first place; if claiming the standard deduction, there is no benefit to donating appreciated securities as the deduction applies instead of - not in addition to - the standard deduction. Even if the reality is that the client is making a large enough donation of appreciated securities that the charitable deduction created by the contribution may itself be enough to exceed the standard deduction threshold, the value is still limited. For instance, the standard deduction for a married couple both over age 65 is $14,600 in 2013; if the client donates $15,000 of appreciated securities, the charitable deduction of $15,000 exceeds the standard deduction of $14,600 (so the client will itemize). However, the reality is that the strategy only produces a charitable deduction that is $400 larger than just claiming the standard deduction, while doing a QCD would produce tax savings based on the entire $15,000 amount. Thus, donating appreciated securities really works best when the client has enough deductions to itemize before including the charitable contributions themselves.

And of course, the reality is that the decision to donate appreciated securities is a moot point if the client has no appreciated securities available to donate in the first place, whether because investment positions are down, the highly appreciated securities are held within IRAs (which are not eligible for the appreciated securities treatment), because the available securities are not transferrable, due to the fact that the receiving charity isn't set up to receive securities as gifts, or simply because the client isn't making a large enough contribution to merit the use of appreciated securities in the first place. In situations where the contribution will be made by cash or check, at worst using QCDs will come out with equal benefit, and often will be slightly more tax efficient. Nonetheless, while QCDs may be effective as an alternative to cash/check contributions for smaller dollar amounts, clients should still recognize that if the dollar amounts are feasible, using appreciated securities are still usually the better (tax) route!

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