I’ve heard it said many times that Americans, as a whole, give more than $300 billion per year to charity. Obviously, charitable giving is a deep conviction embedded in our nation’s Christian principles which to me, is drastically different from of our nation’s passion related to income taxes. But, at least for now, our government still sees value in allowing tax deductions for charitable giving, as The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
One of the most recent changes in this legislation related to tax deductions for charitable purposes is the tax-free distribution from an IRA to a qualified charity. This provision is an extension from 2009 that allows a tax-free distribution to charitable organizations from an IRA up to $100,000/yr., and only for individuals age 70-1/2 or older. Because of the late tax legislation passage, a special provision allows a deduction to be taken in 2010 for any IRA-qualified charitable distribution completed by January 31, 2011. Any other IRA-qualified charitable distribution after January is only effective for the year 2011, and is required to be completed by December 31, 2011.
Most will wonder if there’s a difference between donating to charity from IRA income and doing an IRA-qualified charitable distribution. The answer is most notably “yes.” And here’s why: any qualified charitable distribution to a qualified charity directly from your IRA is a deduction referred to as “above the line” before calculating AGI (Adjusted Gross Income). That contrasts to a general charitable deduction, regardless of where the money comes from, which is a “below the line” deduction flowing from Schedule A. The main difference between the two is that the latter is subject to a standard deduction threshold and possibly income phase-out limitations, which may affect the contribution’s true deductible benefit.
For example: A married couple both over the age of 70-1/2 with pension income of $25,000/year, social security income of $25,000/yr. and IRA withdrawal income of $25,000/year totaling a joint AGI of $75,000/year, haven’t had enough deductions to itemize on their personal tax returns since they retired. Therefore, they generally default to the standard deduction, as it gives them the largest deduction to arrive at taxable income. Let’s also assume they donate 10% or $7,500/yr. to charity. Based on these details alone, this couple never gets the tax deduction benefit for their $7,500 charitable donation, as they never exceed the standard deduction already allowed.
However, in 2011, this client’s yearly charitable deduction can be effectively maximized for tax purposes with just with a little cash flow change. If the client makes a qualified charitable distribution of $7,500 from their IRA directly to the charities of their choice, while reducing their direct IRA income withdrawals from $25,000 to $17,500 (the net of the $7,500 yearly donations), the effective savings would be roughly $2,000 in Federal taxes.
So how does this work? Per my recommendation, the $7,500 contribution is no longer a charitable deduction item on Schedule A, but an IRA-qualified charitable distribution, reducing the total IRA distributions listed as taxable income on the tax return from $25,000 to $17,500. Indirectly, this reduction has a lesser effect on the taxable amount of Social Security income due to the nature of its taxation calculation, from $21,250 (85% of $25,000) to roughly $15,350 (effectively 61% of $25,000). Therefore, the client’s complete AGI has dropped from an estimated $71,250 ($25,000 pension + $21,250 taxable social security + $25,000 IRA income) to $57,850 ($25,000 pension + $15,350 taxable social security + $17,500 IRA income). The client will still receive the “below the line” standard deduction (assuming they do not have enough to itemize) before their taxable income is computed. This small change in cash flow saves roughly $2,000 in federal taxes based on the assumed situation.
Furthermore, depending on the tax bracket the clients were in when they contributed the $7,500 to an IRA many years ago, they could actually be making a return on their money. For example: if they were in a 20% bracket when they contributed to the IRA, they effectively saved themselves $1,500 ($7,500 x 20%) in taxes when contributing the $7,500 years ago. Assuming that, this one cash flow management recommendation effectively returned the client 26.6% ($2,000/$7,500 x 100%). The client saved the tax liability of 20% that was deferred when the money was contributed to the IRA plus an extra 6.6% (26.6% - 20%), demonstrating that a return on your money is not just investment related, but highly cash flow and tax planning sensitive, as well.
For those age 70-1/2 and older with AGI exceeding $75,000/year, the same cash flow management recommendations for 2011 are a must if you’re making charitable contributions and still unable to itemize on your tax return. However, do realize the tax benefits will not be as dramatic as the example listed above due to the phase-out limitations on how social security income is taxed. As such, the need for comprehensive wealth management involving tax and cash flow planning is a must, especially in years of drastic tax law changes.