Weighing A Qualified Charitable Distribution (QCD) From An IRA Vs Donating Appreciated Investments?

Benefits Of Doing A QCD From An IRA

The primary benefit of doing a Qualified Charitable Distribution (QCD) from an IRA to satisfy a charitable bequest is that it allows the funds to come out of an IRA without any tax consequences. In general, this makes the QCD an appealing way to ‘use’ IRA funds, and even more so since the direct charitable distribution can satisfy a Required Minimum Distribution obligation (which there must be, since QCDs are only permitted for those who are already at least age 70 ½ on the distribution date).

Notably, though, the reality is that anyone who is subject to an RMD and has a desire to contribute to charity could always just take the RMD proceeds and use them to make a charitable donation. The IRA distribution would be reported as income, but the subsequent charitable contribution – using the dollars from the RMD, or simply any other equal dollar amount that is contributed – would largely offset the tax consequences anyway.

Example 1. Charlie is 73 and has an $8,000 RMD from his IRA this year, and also plans to contribute at least $8,000 to a charity. Since he’s already taken his RMD – and will have to report the $8,000 distribution in income for tax purposes – he simply writes an $8,000 check to the charity, with the plans to use the $8,000 charitable deduction to offset the $8,000 of RMD income.

Of course, the caveat to this strategy of simply using a charitable donation – and the associated deduction – to offset an RMD is that the two rarely offset each other perfectly.

For instance, the Required Minimum Distribution is reported as income on the front page of the tax return, and increases Adjusted Gross Income, which can indirectly impact everything from the threshold for deducting medical expenses and miscellaneous itemized deductions, to the phase-in of Social Security taxation, and the phase-out of itemized deductions and personal exemptions.

Similarly, the charitable contribution is reported as a “below-the-line” itemized deduction, which means it’s only valuable for those who itemize in the first place (which is a non-trivial threshold, given that with the extra amount for being over age 65, a senior married couple’s standard deduction is a whopping $15,100 in 2016). And then there’s the charitable deduction AGI limitations for those who make “large” charitable contributions (at least, relative to their income).

The end result is that while taking an RMD as income and making a charitable deduction to offset it may “mostly” neutralize the tax impact, it is rarely as clean as the “perfect” pre-tax deduction that occurs by doing a QCD directly from the IRA to a charity.

Example 2. Andrew and Harriet are 74 years old. Between the two of them, they have $45,000 of Social Security benefits, $40,000 of portfolio income, $35,000 from Andrew’s military pension, and Andrew faces a $30,000 RMD from his $714,000 IRA. In addition, the couple wish to make a significant bequest to their alma mater this year, and have pledged a $30,000 donation (to offset their looming RMD obligation).

If the couple commits the $30,000 RMD directly to the charity as a qualified charitable distribution, the couple’s AGI is $40,000 (portfolio income) + $38,250 of taxable Social Security benefits + $35,000 pension = $113,250. They will be eligible for 2 personal exemptions of $4,050 each, and their itemized deductions include paying $5,500 in state income taxes, $4,000 in property taxes, $11,000 in mortgage interest, and $8,000 in investment management fees (which are limited to $5,935 in excess of the 2%-of-AGI floor). Thus, their total deductions are $34,535, and their taxable income is $78,715. Based on the 2016 married filing jointly tax tables, this puts the couple in the 15% tax bracket, with a total tax liability of $11,221.25.

By contrast, if the couple were to take the $30,000 RMD directly, their AGI would rise to $143,250. The subsequent $30,000 contribution to their alma mater would produce a $30,000 tax deduction, but their investment management fee deduction would fall to only $5,335 (due to the higher 2%-of-AGI threshold). As a result, the couple’s total deductions would be $63,935, and their taxable income would be $79,315, resulting in a tax liability of $11,371.25.

The end result is that while the couple takes a $30,000 RMD and contributes $30,000 to charity, their net tax liability rises by $150. This “tax slippage” is due to the fact that the higher income from the RMD increased their AGI and adversely impacted their miscellaneous itemized deductions in a manner that the charitable deduction could not perfectly offset.

Or viewed another way, utilizing the QCD rules over “just” donating to the charity directly saves the couple $150 in taxes on a $30,000 contribution (or a 0.5% marginal tax rate savings), because the QCD is slightly more tax efficient way to engage in charitable giving.

QCDs vs Appreciated Securities To Minimize The IRA RMD Tax Bite

A significant limitation to the benefit of donating the proceeds of an RMD (or donating any cash to charity, and using the charitable deduction to offset the income from an RMD) is that cash donations are not necessarily the most effective charitable giving strategy, compared to alternatives like donating appreciated securities instead.

The reason is that under IRC Section 170, an individual who donates a stock or other investment that has appreciated in value and has been held for at least 12 months (eligible for long-term capital gains treatment) is able to deduct the full fair market value of the investment as a charitable deduction, without being forced to recognize the capital gain in the process. Instead, the capital gain just “disappears” entirely. (Although notably, the property must be held long enough to be eligible for long-term capital gains treatment, as the charitable deduction for investments with a short-term gain is limited to just the cost basis of the investment under IRC Section 170(e)(1)(A).

Example 3. Rebecca has $10,000 of Apple stock that she purchased years ago for just $2,000. She has decided that she will use the Apple stock to satisfy her charitable giving bequest for the year. Accordingly, Rebecca donates the $10,000 of Apple shares, in kind, to the charity. This provides Rebecca a $10,000 charitable tax deduction, even though she could never have used the whole $10,000 for herself, as a liquidation of the stock would have trigger $1,200 in long-term capital gains taxes (assuming a 15% long-term capital gains rate on the $8,000 gain). Thus, by donating appreciated securities, Rebecca obtains a $10,000 tax deduction for property that would have only be worth $8,800 if she tried to use it for herself!

In the context of trying to minimize the tax impact of an RMD through charitable giving, this favorable treatment is notable, as it means that while doing a QCD from an IRA may be more appealing than just donating the cash proceeds, it may still be inferior to donating appreciated investments from the portfolio instead.

Example 4. Continuing the earlier example #1, assume that Andrew and Harriet decided to take their $30,000 RMD in cash and offset the tax consequence by donating $30,000 of highly-appreciated stock that had a cost basis of only $10,000. While the strategy produces the same tax liability of $11,371.25 that occurred when $30,000 of cash was donated, the couple also saves $3,000 of long-term capital gains taxes that otherwise would have been owed someday on the $20,000 gain (assuming a 15% long-term capital gains rate).

In other words, while a qualified charitable distribution from an IRA is slightly superior to contributing cash, donating appreciated securities is far superior to “just” a qualified charitable distribution from an IRA. The reason is that donating either as a QCD or with cash is a pre-tax contribution to charity, but contributing appreciated securities is a pre-tax donation and permanently avoids a long-term capital gains tax liability that otherwise would have been owed in the future.

In addition, it’s notable that donating appreciated securities also has the potential to be tax deductible for contributions to a donor-advised fund, a charitable remainder or charitable lead trust, or a private foundation – all charitable types where a QCD is not permitted in the first place.

Tax Slippage When Donating Appreciated Investments Still Loses To IRA Charitable Distributions

When evaluating whether to donate appreciated investments or do a qualified charitable distribution from an IRA, it’s notable that the larger the embedded capital gains exposure, the more substantial the benefit for donating a stock, ETF, mutual fund, or other investment that has been appreciated in value.

However, the greater the “tax slippage” of reporting an RMD in income and trying to claim an offsetting charitable deduction, the less appealing it is to “just” to donate appreciated securities.

Factors That Increase Tax Slippage

As noted earlier, tax slippage occurs when the increase in income (or specifically, the increase in Adjusted Gross Income) from an RMD triggers additional tax consequences, such as the phase-in of Social Security taxation, the phaseout of itemized deductions or personal exemptions, or the thresholds for specialized deductions like medical expenses and miscellaneous itemized deductions.

In addition, to the extent that the charitable deduction cannot fully be utilized, either because the donor wasn’t itemizing deductions in the first place, or because the charitable deduction limits are being reached, additional tax slippage may occur. (Although notably, the Pease limitation on itemized deductions does not adversely impact charitable contributions, although additional RMD income might.)

A combination of both factors can result in scenarios where donating appreciated securities is actually worse than simply doing a QCD from an IRA.

Example 5. Harry is 72 years old, lives on a combination of $25,000/year of Social Security and another $25,000/year of interest income from his portfolio, and has an $87,000 IRA faced a $3,400 RMD this year. In addition, Harry gives several thousand dollars annually to the American Cancer Society, in memory of his late wife who passed away from leukemia. In the past, Harry donated low-basis stock from his brokerage account to the American Cancer Society to offset the tax consequences of his RMD, and now he would like to assess the tax savings benefit if he simply did a qualified charitable distribution directly from his IRA to the charity to satisfy his RMD obligation.

Currently, Harry’s AGI is $25,000 (ordinary income) + $7,475 (the taxable portion of his Social Security) = $32,475. Since Harry has only $6,000 of itemized deductions, he instead claims the $7,850 standard deduction (including the additional amount for being over age 65), and also receives a $4,050 personal exemption, which brings his taxable income down to $20,575. Based on the 2016 individual tax tables, this puts Harry in the 15% tax bracket, with a total tax liability of $2,622.50.

By contrast, if Harry were to take the $3,400 RMD directly, his income would increase by $3,400. In addition, the higher income would also phase in the taxability of $2,890 of his Social Security benefits, boosting his total AGI to $38,765. The subsequent $3,400 stock donation to the American Cancer Society would produce a $3,400 tax deduction, bringing his total tax deductions to $9,400 (although since he already had a $7,850 standard deduction, only the last $1,550 produces any tax savings). Thus, Harry’s final taxable income is $38,765 - $9,400 - $4,050 = $25,315, which produces a tax liability of $3,333.50.

In other words, because of the indirect effects of Harry’s additional income and the limited value of additional itemized deductions (when he already claims the standard deduction), Harry will owe an additional $711 of taxes by taking his RMD and donating it, versus simply doing the QCD from the IRA, even though both involve a “pre-tax contribution” to charity! In fact, even if the cost basis of the stock were $0/share, his potential tax liability at a 15% capital gains rate would be only $510 of additional tax savings, compared to $711 by doing the QCD. (And notably, Harry is actually eligible for the 0% long-term capital gains rate, which just makes donating his low-basis stock even less appealing!)

IRA Charitable Giving Strategies Beyond Just RMDs

As shown, there is virtually always a tax benefit for doing a qualified charitable distribution from an IRA over just taking an RMD and separately donating cash (or writing a check) to a charity. And in extreme circumstances, the tax slippage can be so severe, it’s even better to do a QCD rather than donating appreciated low-basis investments to charity.

However, the QCD rules are broader than “just” covering an RMD obligation from an IRA. Any IRA owner is permitted to do up to $100,000 per year in QCDs from an IRA to a charity, which may be far in excess of their RMD alone. (And up to $200,000 is possible for a married couple, as long as each contributes up to the $100,000 maximum from his/her own IRA, and each is over the requisite age 70 ½ on the date of their respective distributions.)

Generally speaking, larger QCDs will continue to be appealing in situations where the charitable deduction could not be fully utilized directly – either because some or all of the charitable deduction falls below the threshold of the standard deduction in the first place, or because the charitable contribution is so large that it reaches the 30%- or 50%-of-AGI contribution limits and must be carried forward.

As a result, larger QCDs will tend to be most appealing for those with very little in other deductions at all, or for those who are already doing significant charitable giving and may be close to the charitable deduction limitations. QCDs may be especially desirable for those who are already at the full charitable deduction limits (or worse, already trying to use prior carryforwards after reaching the limits in prior years), because the tax-free QCD can be done on top of the charitable contribution limits (as since the QCD is never reported as a deduction at all, it’s not counted in the charitable limits).

When NOT To Do A Qualified Charitable Distribution From An IRA

Notwithstanding the prospective tax benefits of doing a qualified charitable distribution from an IRA (or donating low-basis investments), it’s important to note that ultimately, the strategy is only worthwhile for those who otherwise already plan to contribute to charity.

For those who do not actually have a desire to donate the money in the first place, the ‘optimal’ strategy is still to take the RMD, pay the taxes that are due, and keep whatever is left. In other words, from a pure wealth maximization perspective, it’s still better to keep the $0.60, $0.70, or $0.80 cents on the dollar left over after an RMD occurs, than to donate it and keep $0.00 instead.

Thus, while a QCD can be an effective way to leverage the tax benefits of charitable giving, for those already over age 70 ½ who have an IRA (and face RMDs), it should still only be done after deciding to make a charitable donation in the first place!

So what do you think? In what circumstances do you recommend a qualified charitable distribution from an IRA? When do you suggest donating low-basis investments instead? Please share your thoughts in the comments below!