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 a little 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?

A QCD transfers funds directly from your individual retirement account to an eligible charity. These donation funds aren’t included in your taxable income, and they also count toward your required minimum distribution (which begin at age 72 for those born in 1950 or earlier, age 73 for those born between 1951-1959 and 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. 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?

To make an IRA qualified charitable distribution, you must be at least 70½ years of age – even if you haven’t started taking your RMDs yet.¹ 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 especially beneficial if your RMD income would push you into a higher tax bracket, therefore, requiring you to pay more each year.

Once you reach the age of 70½, you can start transferring money from your IRA and directly donating it to a qualified charity. 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.

Regardless of the IRA you use, you’re allowed to give up to $100,000 in qualified charitable contributions each tax year.¹ However, it’s important to note that not every charitable organization is eligible to receive this kind of donation.

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

You may already be considering QCDs for federal income tax purposes. But 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.

But by making a QCD, you can donate your whole RMD amount tax-free and potentially move down a level in the tax bracket. This allows you to avoid the 25% penalty imposed on those who don’t take the required amount. Each IRA distribution also reduces the overall account balance, which could lower your required minimum distributions down the line.

Unrelated to your taxes, another notable benefit can have a great impact on the charitable cause you choose to support. 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.

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

• Your donations cannot exceed $100,000 in a single tax year
• Donations must come from an IRA and go directly to a qualified charitable organization
• While other retirement plans like your 401k have RMD requirements, you cannot use RMDs to make a charitable distribution

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. Ultimately, the decision to use an itemized or standard deduction will depend on your specific circumstances and charitable giving plan.

While you won’t be able to itemize QCD deductions, you’ll still have to report them on your individual income tax return. The IRS has detailed instructions on filling out Form 1040, but here’s a quick rundown of how to report a QCD charitable deduction:⁴

1. On line 4a for “IRA distributions,” fill in the full amount of your qualified charitable donations for the tax year
2. Moving over to 4b, your “Taxable amount,” put a zero on the line as QCDs are tax-free deductions
3. Next to line 4b, write or type “QCD”

In addition, you might have to file Form 8606 for Nondeductible IRAs depending on if you:

• Made a QCD from a traditional IRA that provided you with an additional distribution throughout the year
• Donated the same RMD amount as would normally be distributed from your IRA and included it in your taxable income
• Made a QCD from a Roth IRA

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. Remember, it’s best to work closely with your tax planner and financial advisor 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 an advisor today to get started.