HOW DO CHARITABLE DONATIONS AFFECT TAXES

If you share a desire to help those in need through charitable giving, why not take advantage of some tax-savvy strategies along the way?

A charitable donation plan can help maximize your impact and minimize your end-of-year taxes. It’s a great way to give back to causes or your community while saving some for yourself or other philanthropic ventures. One way to achieve this mutually beneficial outcome is through a qualified charitable distribution.

But what is a QCD, and what’s the tax benefit of using one?

WHAT IS A QUALIFIED CHARITABLE DISTRIBUTION?

A QCD transfers funds directly from your individual retirement account to an eligible charity. This allows you, as a donor, to make a charitable contribution directly from your IRA, which can provide significant tax advantages. These IRA distributions that were given to the charity aren't included in your taxable income and they also count toward your required minimum distribution (which begin at age 73 for those born from 1951 through 1959 or age 75 for those born in 1960 or later). As a result, you could avoid being placed in a higher tax bracket, reducing your overall liability at the end of the year. This tax-saving strategy can provide significant tax relief for taxpayers who are required to take RMDs. Keep in mind, taking an RMD does not always result in being placed in a higher tax bracket, but if that’s the case for you, a QCD could benefit you.

Whether you’re gift planning for the first time, or you’re looking for more ways to save on taxes, an IRA QCD is an excellent way to make a charitable contribution.

However, not everyone qualifies for this type of planned giving. So, who does?

WHO CAN MAKE AN IRA QUALIFIED DONATION?

To make an IRA qualified charitable distribution, you must be at least 70 ½ years of age – even if you haven’t started taking your RMDs yet. If you are age 72 or older and you’re taking them, the IRS does allow you to satisfy all or part of your RMD through these types of donations. This is beneficial because, by making a QCD during your RMD periods, any QCD amount you make will can immediately lower your taxable income and help reduce your taxes. Regular charitable donations only lower your taxable income if you itemize deductions. This means that older taxpayers have the opportunity to make cash donations directly from their IRAs, which can be a valuable tax break.

HOW DO QUALIFIED CHARITABLE DISTRIBUTIONS WORK?

Once you reach the age of 70 ½, you can start transferring money from your IRA and directly donating it to a qualified charity. These cash contributions must be made directly to a public charity or other qualified charitable organization to qualify as a QCD. QCDs are reportable, but not taxable. So, unlike regular withdrawals from a traditional IRA, QCDs are tax-free. While you can make donations from a Roth IRA, there’s no additional benefit as distributions from these accounts are already exempt from federal taxes. You can also make direct donations from a SIMPLE or SEP IRA if the plan is inactive. Making a QCD from an inherted IRA is also an option as long as you meet the QCD age requirement.

Regardless of the IRA you use, you’re allowed to give up to $105,000 in qualified charitable contributions in 2024. The QCD limit, which is indexed for inflation, will increase to $108,000 for the 2025 tax year. This limit applies to the total amount of tax-deductible donations you can exclude from your gross income for the year. However, it’s important to note that not every charitable organization is eligible to receive this kind of donation.

WHO CAN RECEIVE A QUALIFIED CHARITABLE GIFT?

The only way you’ll be able to receive a tax deduction is if your charitable contribution goes to a qualified organization. While you can always ask an organization directly, the IRS also has a helpful online tool to search for eligible charities (2). For a more extensive list of different types of organizations that may qualify, visit Publication 526 on the IRS website (3).

PROS AND CONS OF CHARITABLE CONTRIBUTIONS

You may already be considering QCDs for federal income tax purposes. Understanding how charitable donations affect taxes can help you decide if this strategy aligns with your financial goals. So before you make your first donation, it’s important to understand the benefits and drawbacks of this planned giving strategy to understand if it’s right for you.

When it comes to lowering your overall income tax, QCDs can help in reducing your required minimum distribution. Normally at their RMD age, an IRA owner would need to withdraw the full RMD amount, which increases their gross income and, therefore, tax obligations.

By making a QCD, you can donate some or even your entire RMD amount. Normally, RMDs are included in your adjusted gross income but with a QCD, the amount donated is excluded, which lowers your AGI. This reduction in AGI can potentially decrease your overall tax liability. Additionally, lowering your AGI may help reduce your Medicare Part B and D premiums, as these premiums are based on your AGI. In contrast, regular charitable donations increase your itemized deductions and reduce your taxable income, but they do not affect your AGI. Since Medicare premiums and some tax credits are tied to your AGI, a QCD can offer an added benefit by helping lower your AGI directly.

Even if you are not yet at RMD age, a QCD might appear neutral on your tax return – a wash – but it still can reduce your IRA balance. Over time, this lower IRA balance can decrease your future RMDs, potentially lowering your taxable income in later years.

Unrelated to your taxes, another notable benefit can have a great impact on the charitable cause you choose to support. Your charitable activity can provide more funds to the charity, as the entire amount of your donation goes directly to the nonprofit organization without any taxes being withheld. Instead of taking money out of an IRA, paying income tax on that amount and then giving the after-tax amount to the charity, with a QCD, the amount that would have gone to pay income taxes goes instead to the charity, so the net result is more money for the charity.

Of course, no tax-advantaged vehicle comes without potential drawbacks. In the case of QCDs, there are some restrictions that you should consider.

DONATIONS ARE LIMITED AND MUST COME FROM AN IRA ACCOUNT

To receive the charitable deduction offered by QCDs, your donation must meet specific criteria:

• Your donations cannot exceed the QCD limit ($105,000 in 2024; $108,000 in 2025) in a single tax year. This cap applies to the total amount of cash donations you can make as QCDs each year.
• Donations must come from an IRA and go directly to a qualified charitable organization. Donations to donor-advised funds, private foundations and certain other organizations are not eligible for QCD treatment.
• While other retirement plans like your 401k have RMD requirements, you cannot use those RMDs to make a charitable distribution. Therefore, only IRAs are eligible for this specific tax break.

QCD CONTRIBUTIONS CAN’T BE CLAIMED AS AN ITEMIZED DEDUCTION

The other important consideration around QCDs is that you won’t be able to claim them as a separate itemized deduction because it’s not counted as taxable income. This means you receive the tax benefit upfront by excluding the amount from your gross income, rather than later through itemized tax deductions. Ultimately, the decision to use an itemized or standard deduction will depend on your specific circumstances and charitable giving plan.

REPORTING QCD CHARITABLE GIVING ON TAXES

While you won’t be able to itemize QCD deductions, you’ll still have to report them on your individual income tax return. It’s important to accurately report your QCDs to help ensure you receive the appropriate tax advantages. The IRS has detailed instructions on filling out the appropriate forms. You will receive a 1099-R for the total amount withdrawn from your IRA for the year. However, the 1099-R will not specify how much of that amount was used for a QCD. It’s important to inform your tax professional of the QCD amount so they can manually adjust the taxable amount on your tax return. If you don’t specify this to your tax professional, they won’t know you made a QCD, and you could lose the associated tax benefits. Be sure to keep detailed records and provide sufficient information to help your tax professional help you maximize the benefits.

DOES AN IRA QCD MAKE SENSE FOR YOU?

While QCDs can be a great way to support worthy causes and lower your tax liability, they aren’t always the right choice for every situation. Other strategies, such as donating appreciated securities or using donor-advised funds, may provide additional tax benefits like avoiding capital gains tax. Furthermore, making charitable contributions can also play a role in your estate planning by potentially reducing your estate tax obligations. Remember, it’s best to work closely with your financial planner, tax professional and estate planning attorney to understand whether or not you can take full advantage of a QCD.

At Edelman Financial Engines, we’re here to help. Our financial planning services offer an integrated wealth management approach to support your goals and help preserve your wealth. Reach out to one of our financial planners today to get started.