Complications to the IRA-to-Charity Distribution Provision

Article Highlights

  • IRA Contribution Age Restrictions Removed
  • Required Minimum Distributions
  • Qualified Charitable Distribution
  • Tax Trap

Individuals are required to begin taking distributions from their IRA when they reach a certain age. That age was 70½ until Congress passed the SECURE Act in late 2019 which made significant changes to the retirement plan provisions of the tax code, one of which was to up the age for beginning required minimum distributions (RMD) to age 72. That change was supposed to occur with 2020 distributions, but due to the Covid-19 pandemic, Congress waived RMDs for 2020. So, 2021 is actually the first year that the age 72 rule is effective.

Prior to the passage of the SECURE Act, the tax code also restricted contributions to IRAs by individuals once they reached age 70½, which coordinated with the prior requirement to begin RMDs. That restriction has been eliminated, and as of 2020, individuals may make IRA contributions at any age provided they have earned income.

The tax code also includes another provision that allows taxpayers to transfer up to $100,000 from their IRA to qualified charities. The tax provision is called a Qualified Charitable Distribution (QCD), and has been a popular way for retirees to make charitable contributions that can provide significant tax benefits. Here is how this provision, if utilized, plays out on a tax return:

(1) The IRA distribution is excluded from income.
(2) The distribution counts toward the taxpayer’s RMD for the year; and
(3) The distribution does NOT count as a charitable contribution deduction.

At first glance, this may not appear to provide a tax benefit. However, by excluding the distribution, a taxpayer lowers his or her adjusted gross income (AGI), which helps for other tax breaks (or punishments) that are pegged at AGI levels, such as medical expenses if itemizing deductions, passive losses, taxable Social Security income, and so on. In addition, non-itemizers essentially receive the benefit of a charitable contribution to offset the IRA distribution.

Whether intentional or an oversight by Congress, the SECURE Act did not change the age at which a taxpayer can begin making QCDs and left it at age 70½ – no longer in synchronization with the revised RMD age of 72.

Tax Trap – Unfortunately, that has created a situation that can be detrimental for individuals who have earned income and wish to utilize the QCD provisions and also continue to contribute to an IRA after age 70½.

The problem being that a QCD must be reduced by the sum of IRA deductions made after age 70½ even if they are not in the same year, causing unexpected tax results for taxpayers that are not aware of this complication. This is best explained by a couple of examples.

Example #1 – Jack makes a deductible IRA contribution of $7,000 when he is age 71 and another $7,000 contribution at the age of 72. He claims an IRA deduction of $7,000 on his tax return for each year. Then later when he is 74, he makes a QCD in the amount $10,000 to his church’s building fund. Since Jack had made the IRA contributions after age 70½, his QCD must be reduced by the post-70½ contributions that were deducted, and as a result, the $10,000 is a taxable IRA distribution ($10,000 – 14,000 = <$4,000>). However, he can claim $10,000 to the church building fund as a charitable contribution on Schedule A if he itemizes his deductions. In the next year, Jack makes a $5,000 QCD to the university where he got his degree. The excludable amount of the QCD is $1,000 ($5,000 – $4,000 = $1,000). The $4,000 is the amount that remained from post-age 70½ IRA contributions that didn’t previously offset QCDs. Jack includes $4,000 as taxable IRA income and can deduct $4,000 as a charitable contribution if he itemizes. No amount of post-age 70½ IRA contributions remains to reduce the excludable amount of QCDs for subsequent taxable years.

Example #2 – Bob makes a traditional IRA contribution of $7,000 when he is age 71 and another $7,000 contribution at the age of 72 and deducts the IRA contributions on his returns. Then later when he is 74, he makes a QCD in the amount $20,000 to his church’s building fund. Since Bob had made the deductible IRA contributions after age 70½, his QCD must be reduced by the $14,000. As a result, of the $20,000 QCD, $14,000 is a taxable distribution, $6,000 is nontaxable, and Bob can claim a $14,000 charitable contribution

All this can become quite complicated. If you are considering making a QCD and made IRA contributions after age 70½ and don’t understand the tax ramifications, you should consider consulting with this office before you make the distribution.