Under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (or the "Tax Relief Act" for short!) signed into law by President Obama on December 17th, taxpayers over age 70 1/2 may once again make up to $100,000 per year of so-called "qualified charitable distributions" out of their IRAs and directly to a charity, for the 2010 and 2011 tax years. Doing so allows the entire amount of the distribution to be excluded from income, effectively ensuring that those IRA dollars are never taxed, while also satisfying charitable goals. Unfortunately, the problem is that this is actually a remarkably INefficient way to make significant charitable gifts, compared to other alternatives available under the tax law!

The popularity of qualified charitable distributions from IRAs appears to stem from the mindset that since an IRA is pre-tax, and a direct contribution allows that income to be excluded from taxation, that therefore the entire amount was contributed pre-tax and that it must be an effective strategy. But while it is true that completing a direct contribution from an IRA is pre-tax, this is hardly unique to contributing from an IRA; in point of fact, the entire purpose of a "charitable deduction" under the regular tax system is to afford the exact same treatment!

For instance, consider the results when an individual receives $1,000 of income, and chooses to contribute it to a charity. The $1,000 is reported in income. The individual then receives a $1,000 charitable deduction for making the contribution. The net result: $1,000 of "pre-tax" income was contributed to the charity, because the charitable deduction offset the income.

In other words, "almost" all of the value of an up-to-$100,000 qualified charitable distribution from an IRA could be re-created, simply by withdrawing up to $100,000 of the money from the IRA, and then contributing to a charity, producing $100,000 of income from the withdrawal and a $100,000 charitable deduction from the contribution. The caveat, though, is that these don't quite offset perfectly in the real world. The $100,000 of income increases Adjusted Gross Income, may impact phaseouts based on AGI, could cause more Social Security benefits to be taxed, etc., while the charitable deduction may be limited (at least in the current year) with a portion that must be carried forward and used in future years. So while the qualified charitable distribution from the IRA is, almost by definition, 100% effective (because all of the income is outright excluded), creating income and trying to offset it with a charitable deduction might only be 95% to 99% effective.

Contrast this, though, with another popular charitable gifting strategy: donating appreciated securities. In this case, the taxpayer receives a charitable deduction to offset income, in the same manner of donating from cash or another income source. However, in addition, the individual also gets to exclude the long-term capital gains attributable to the appreciation, causing that income to truly "disappear" for tax purposes. The net result is a full pre-tax contribution, and excluding capital gains from income, generating even more after-tax wealth. A few examples might help to illustrate:

John, who is 74 years old, has (in addition to other wealth that he uses to maintain his standard of living) three accounts: a $100,000 IRA, a $100,000 checking account, and $100,000 of ultra long-term appreciated stock with a near-$0 cost basis. We will assume John faces a 40% state + Federal ordinary income tax bracket, and a 20% state + Federal long-term capital gains rate. He wishes to contribute $100,000 to a charity.

Scenario A) John contributes $100,000 from his checking account. In return, he receives a $100,000 tax deduction, which can nearly offset all of the income from his IRA. The net result: "almost" all of his IRA is tax-free (we'll assume he can spend $98,000 of it, with $2,000 owed in taxes due to the not-quite-perfect-offset of the deduction), and his appreciated securities will be worth $80,000 after taxes. Final, spendable wealth: $178,000.

Scenario B) John contributes $100,000 directly from his IRA to a charity, since he's over age 70 1/2. In return, he is able to exclude the entire $100,000 from income. He still has his $100,000 checking account available, and he still has $80,000 of after-tax value for his appreciated securities. Final, spendable wealth: $180,000.

Scenario C) John contributes his $100,000 of appreciated securities to the charity, and since they're long-term he's able to exclude the entire amount of capital gains from income, while also still claiming a full $100,000 tax deduction. This allows John to almost fully offset his IRA income (again, we'll assume he can spend $98,000 of it, with $2,000 owed in taxes due to the not-perfect-offset of the deduction), and he still has $100,000 in his checking account. Final, spendable wealth: $198,000!

As the scenarios above show, there is some tax-efficiency value to completing a direct contribution from an IRA; the difference between scenarios A and B represents the benefit of having a direct exclusion of IRA income, instead of just trying to offset it with an outside charitable deduction. Nonetheless, it is still vastly inferior to contributing appreciated securities, which results in far more final, spendable wealth, because the client enjoys both the full charitable contribution and the opportunity to exclude long-term capital gains from income!

Notably, this approach is still effective even if the charitable deduction cannot fully be used immediately. Even if the value of the $100,000 charitable deduction is spread out over a few years, the net present value of it is still worthwhile when it allows the client to exclude a large long-term capital gain! Similarly, while some clients have also been excited to use qualified charitable contributions to satisfy RMD requirements, it is still true that the appreciated securities scenario is superior; simply use the charitable deduction from the donation to offset the income from the RMD!

Of course, the contribution of appreciated securities doesn't "always" work out better. It may be inferior if the contribution is modest and the client doesn't itemized deductions. If the amount of capital gains to avoid is modest, and most of the charitable contribution will be carried forward (or is even at risk of being carried forward until it is lost), the strategy may be less effective. If there is state taxation involved and the state provides different and less favorable treatment of charitable deductions than the Federal tax system, the direct IRA contribution may be preferable (assuming, of course, that the state does allow for that treatment at the state level!).

But the bottom line is that for almost all clients, a contribution of any appreciated securities will be superior to making direct contributions from an IRA, and the greater the appreciation, the more value it will provide. In fact, as long as the charitable deduction can be used, virtually any appreciation in securities that can be contributed results in a superior wealth result to contributing directly from an IRA! So in the end, charitable contributions should be viewed merely as a slightly more effective means of donating than contributing cash; it is still quite inferior to contributing appreciated securities!

So what do you think? Have you had clients making contributions from their IRAs? Do you help clients contribute appreciated securities? Will you be thinking different about how you counsel clients on gifting strategies?

  • http://www.innovativefinancial.com DeDe

    Remember that including IRA distributions increases all of the threshholds on Schedule A. Making a direct contribution from an IRA may significantly affect some family’s ability to deduct items like medical expenses and miscellaneous deductions subject to a 2% floor (like advisor fees).

    • http://www.kitces.com Michael Kitces

      Indeed, I’ve included this effect – that’s why in scenario B, only $98,000 of the IRA assumed to be available; the other $2,000 went to taxes because of the effects you’re talking about.

      But bear in mind, the effect really is typically that small. In the “worst case” scenario, adding $100,000 of income increases the medical expense threshold by $7,500 (7.5%), and the miscellaneous itemized deduction threshold by $2,000 (2%). This causes a total of $9,500 of lost deductions. At a whopping 40% tax rate, that’s still only approximately a $4,000 impact for $100,000 of income, allowing the client to still spend the other $96,000. And of course, most clients do not have enough medical expense deductions to claim a full $7,500 above their current threshold, and if the client is subject to the AMT the miscellaneous itemized deduction threshold is a moot point as well.

      Granted, some clients may be impacted by this, but even assuming 40% tax rates and maximum impact, you’re still talking about a deduction that offsets the income by 96%. And most clients will not be impacted this much, and/or face lower tax rates, which reduces the impact; thus my “$98,000 left out of $100,000″ as a general assumption.

      Either way, if you’re saving $5,000, $10,000 or $20,000 of long-term capital gains taxes, the impact still far outweighs the partial impact of higher income with a not-quite-offsetting deduction.

      – Michael

  • DeDe

    “including IRA distributions in income”

  • Steve Smith

    On the other hand, it’s not clear whether it would be better for heirs to inherit stepped-up assets outside of an IRA which could be managed on a tax efficient basis, or a stretch IRA – subject to RMD’s at ordinary income tax rates.

  • Art Dicker

    The concept of making a qualified IRA distribution directly to a charity appeals most to a taxpayer who does not want or need to take his/her RMD. No doubt your arithmetic is correct that it makes better sense taxwise to donate appreciated securities to the charity and then use the RMD to repurchase them, but this introduces another level of complication into the process.
    Best wishes for the New Year!

    • Michael Kitces

      But indeed, this is still part of the point.

      Mr. Client, you have a $10,000 RMD. Your choices are:
      1) Take the RMD you don’t need, pay Uncle Sam a portion of it, and keep the rest; or
      2) Contribute the RMD to charity so you don’t have to pay Uncle Sam a dime.

      Clients often fixate on Scenario 2, because they don’t pay Uncle Sam anything. What they seem to fail to realize is that in Scenario1, they keep 70%-80% of the money (assuming a 20%-30% tax rate). In Scenario 2, they keep 0% of the money.

      You never end out with more wealth by making a charitable contribution of the RMD than you would by just taking the RMD, paying some taxes, and keeping the rest.

      If the client wants to contribute to charity, the appreciated securities are better and the charitable contribution results in less wealth. If the client does NOT want to contribute to charity, then taking the RMD is better and the charitable contribution again results in less wealth.

      The bottom line is that if the client wants to donate, the appreciate securities contribution is more tax efficient. If the client doesn’t want to donate, then the client shouldn’t donate. In neither case does the charitable contribution from the IRA come out better, though.

  • http://ydfs.com Sam TheMoneyGeek

    Thanks for a very interesting article Michael. As with all tax strategies, “your mileage may vary”, so as Michael alluded to, it’s important that a customized projection be run comparing the scenarios for each client to see what strategy works best.

Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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