By: Rob Gordon, MBA, CFP®, AIFA®
Many investors have accumulated significant sums in their qualified retirement plans like IRAs, 401(k)s, and 403(b)s. If you are in that camp, congratulations on your discipline and consistency. While these plans are not usually the best places from which to make a charitable donation – owing to their already tax-advantaged character – they can be used for this purpose very effectively.
The easiest and most straightforward way to make a donation using money from a qualified plan is to liquidate all or a part of the qualified investment, pay the tax and, if applicable, any penalties, and donate. Of course, making that donation at the lowest cost is best. By the lowest cost, I refer to the amount of an IRA distribution that actually gets to the charity after taxes, applicable penalties, and trading/execution costs. Let’s say that you are 50 years of age and your only asset is $100,000 in a Traditional IRA. Let’s also say that you are moved to give $5,000 as soon as possible to a local food bank to address an immediate need. Assuming that you are in a 25% marginal tax bracket, you will spend approximately $6,750 ($5,000 to the charity, $1,250 in taxes plus a $500 early withdrawal penalty.) Not included in this figure are the trading/transaction costs incurred to liquidate the positions. Not to be ignored is the fact that the charitable contribution reduces taxable income which is important especially at higher marginal tax brackets. Assuming you file as a single taxpayer and you itemize, the $5,000 donation saves you approximately $1,250 in taxes. It is important to note that if you have an estate that may be subject to estate taxes at the federal or state levels, it may make sense to use this charitable giving strategy to reduce the size of your taxable estate.
Name the Charity as a Beneficiary
You may also want to consider naming the charity as a beneficiary of your tax-deferred plans. This will allow the assets to pass tax-free to a charitable organization at the account owner’s death. Of course, the step-up in basis benefit is lost in this case as is the ability to stretch out the tax deferral since the recipient is not a person. Under current estate tax rules, a non-spouse person named as the beneficiary of an IRA receives the asset as an inherited IRA and is able to extend the minimum required distributions over their lifetimes. So, if the heir is much younger, they can extend the benefit of tax deferral for a very long time & most likely end up with a substantially larger benefit than the original gift. If an investor wishes to list charities along with persons as beneficiaries, it is best to divide the tax-deferred asset accordingly to create separate IRAs with different beneficiary designations. While the same rules apply to 401(k)s, 403(b)s and similar plans, there are some differences. Congress extended this spousal benefit to anyone who inherits a 401(k). However, it is up to the plan sponsor whether or not they will change their plans to accommodate the new rules. In other words, it is best to transfer your 401(k) or similar plan to an IRA with the beneficiary designations you choose.
Got Roth Conversion Income?
2010 is often dubbed “the year of the Roth Conversion.” The decision to convert a tax-deferred qualified plan such as a traditional IRA or 401(k) is complex. If you make the decision to do it, you can reduce taxable income from the conversion with a substantial charitable contribution. Let’s look at an example. Assume we have a married, 60 year old investor with earned household income of $20,000 and an IRA worth $100,000. Thanks to a large inheritance, she doesn’t anticipate ever needing the money in her Traditional IRA. She decides to convert the entire Traditional IRA to a Roth IRA so that her heirs will be able to enjoy tax-deferred growth for many years after she has passed on. The $100,000 will be added to the $20,000 earned in 2010 resulting in a tax bill of approximately $18,700. Currently, they make annual contributions of $2,000 a year to a local orphanage and they decide to accelerate their giving by contributing $20,000 in 2010. The $20,000 contribution reduces the tax bill by approximately $4,000. Charitable contribution offsets such as these allow investors to convert a larger percentage of qualified plan balances without moving them into a higher tax bracket.
What About the Qualified Charitable Distribution (QCD)?
If you are considering a charitable gift from your qualified plan at all, you have probably heard of the QCD. The Pension Protection Act of 2006 (PPA 2006) made it possible for certain IRA owners to make charitable gifts directly from their IRAs to the charity of their choice. It is referred to as the Qualified Charitable Distribution. Prior to the passing of the PPA 2006, IRA owners seeking to make a charitable contribution were required to pay income taxes on the withdrawal regardless of the ultimate destination of the funds. The rules were very specific:
– The IRA owner must have attained the age of 70 ½
– The limit for charitable gifts was $100,000
– The gift must go directly to the charity
– You could not get a charitable deduction for the gift
– Initially enacted for 2006 and 2007 it was extended through 2009
The House of Representatives passed the American Jobs, Closing Tax Loopholes, and Preventing Outsourcing Act of 2010, H.R. 4213 on May 28th, 2010. If passed by the Senate and signed by the President, this legislation would extend the QCD through December 2010.
As always, consult with your tax professional to see if this makes sense for your particular situation. Saving for retirement is extremely important and you can certainly feel better about your financial involvement in charitable causes once retirement plans are well-defined and adequately funded. Feel free to contact us to advance your charitable intentions.