Kevin Michels, CFP®, EASave Post
Tax season is just around the corner and during this time of year the chatter on how to reduce your tax bill picks up quite a bit. Giving to charities is a popular way to do that, whether your motivation is charitable, financial, or a combination of the two, if the donation is done correctly both parties win!
A typical scenario we run into with our retired clients is although they are donating to charities, they aren’t receiving a tax deduction for doing so. This is simply attributable to the fact that the majority of our retired clients don’t itemize their deductions. A quick refresher on the income tax calculation…
Each taxpayer has the option of itemizing their deductions or taking a standard deduction whichever is higher. Common itemized deductions include charitable donations, mortgage interest, a portion of medical expenses, and property and state taxes. If you total up all your itemized deductions and they aren’t greater than the standard deduction, then obviously you’ll take the standard deduction. For a married couple over age 65, the standard deduction is $15,100.
The Pension Protection Act of 2006 introduced a new provision to the tax code which prevents individuals over the age of 70 ½ from losing their charitable deduction by taking the standard deduction.
It’s called a Qualified Charitable Distribution (QCD). A QCD allows an individual who is subject to required minimum distributions to direct the required minimum distribution to a charity and eliminate that distribution from gross income instead of taking it as an itemized deduction. An ideal client for a QCD would be the following:
Steve and Lori are both age 75 and retired. Steve has an IRA with a balance of $150,000. Per the Required Minimum Distribution rules, he's required to withdraw $6,550 from his IRA before the end of the year. Steve and Lori are able to cover their income needs solely through their social security and pension income, given the choice, they'd rather not withdraw the money from their IRA and incur the additional tax. So, they decide to donate the $6,550 to a local charity. Steve and Lori don’t have many deductions since they no longer have a mortgage, are in good health, and pay minimal property and state taxes. Their total itemized deductions, including the charitable donation, equal $12,000. Since their itemized deductions are less than the standard deduction of $15,100, they'll end up taking the standard deduction when they file their taxes. In essence, they effectively lose the deduction for the charitable contribution to the charity.
However, if Steve and Lori perform a QCD by instructing the custodian of their IRA to direct the distribution straight to the charity of their choosing, without ever taking receipt of the funds, they can exclude that distribution from gross income entirely and still take the standard deduction.
In this case, they would save $982.50 by doing a QCD ($6,550 distribution X 15% tax rate)
Even if you itemize your deductions, I would still recommend doing a QCD since it will lower your adjusted gross income (AGI). Your AGI directly affects your capital gains and dividend tax rates as well as the deductions and credits you can take. The higher up on the tax return you can exclude/deduct income the better!
QCDs are simple and effective for those who are subject to RMDs. If you're not at that point yet, keep an eye out for friends and family who are eligible for this tax saving strategy.