Charitable Transfers Get Maximum Return on 'Minimum Distribution'

NEW YORK ( TheStreet) -- One of the temporary benefits extended for tax year 2013 by the American Taxpayer Relief Act of 2012 was the ability for people age 70.5 and older to transfer up to $100,000 tax free directly from an IRA account to a qualifying charity. These charitable transfers can be used to satisfy the taxpayer's "required minimum distribution" for the year.

Using this technique can result in substantial tax savings. Here is how it works:

Dave Donor, 72, must take a fully taxable required minimum distribution of $4,263 from his IRA this year. Dave also owes $5,000 on a pledge to the Visual Art Center of New Jersey building fund. He can contact the trustee of his IRA account and request that $5,000 be sent directly from the account to the center to cover his required minimum IRA distribution for 2013 and his pledge. The $5,000 is not reported as income on his 2013 Form 1040, but he cannot deduct it as a charitable contribution on his Schedule A.

If this tax benefit had not been extended, Dave would have had to claim $4,263 as gross income on Page 1 of his Form 1040 and claim a $5,000 charitable deduction on Schedule A. The $4,263 would increase his Adjusted Gross Income and could, as a result, increase the taxable portion of his Social Security (or Railroad Retirement) benefits by as much as $3,624, reduce his medical and miscellaneous itemized deductions by up to $426 and reduce or eliminate a number of other deductions and credits affected by AGI, possibly causing him to fall victim to the dreaded Alternative Minimum Tax.

Now the $5,000 IRA transfer is tax free and does not increase his AGI. The additional $737 represents a tax-free withdrawal from his IRA.

There is nothing in the law that limits the number of transfers that can be made during the year, or the number of charities to which the money can be transferred. So Dave can choose to transfer $1,000 each to four different churches or charities and $263 to a fifth. The only requirements are:
  • The taxpayer must be at least 70.5 years old and subject to the required minimum distribution rules.
  • The distribution must be a direct trustee-to-trustee transfer. The IRA trustee must transfer the money directly to the charity; taxpayers cannot get the distribution in their hands, then donate it to the charity.
  • One hundred percent of the transfer must qualify as a charitable contribution eligible to be deducted on Schedule A.
  • The maximum amount that can be excluded from taxable income for the year is $100,000.

Many retired taxpayers who must take a Required Minimum Distributions from an IRA are not able to itemize, due to the additional standard deduction for age 65 or older and the fact that their mortgage is paid off; they therefore get no tax benefit from their charitable contributions. By using a direct transfer to the charity of their choice to satisfy their annual required minimum distribution they will be able to get the full tax benefit for their contribution, as well as possibly reducing their taxable Social Security.

What if there is a "tax basis" in Dave's IRA from nondeductible contributions and part of his RMD is tax-free? If he decides to transfer his entire $4,263 RMD to various charities during 2013 but the calculation from Form 8606 indicates only $3,950 of the distribution would have been taxable, Ely can claim the $313 "return of basis" as a charitable contribution on Schedule A.

Be advised that charitable distributions should be made only from a "traditional" IRA. Because qualified distributions from a Roth IRA are totally tax free to the owner as well as his or her beneficiaries, there is no tax benefit in a direct transfer of funds from a Roth IRA to a charity. In such a case it would be "more better" to take a distribution from the Roth and make a cash contribution to the charity. The Roth distribution is not included in taxable income, and the contribution can be claimed as a deduction on Schedule A.

Qualifying taxpayers may also want to consider making a direct transfer from a traditional IRA to a charity now, instead of having a cash bequest made from their estate. As beneficiaries will be taxed on monies received from an inherited traditional IRA, by making the contributions as a direct transfer now one will:
  • Reduce the tax cost to the beneficiaries of their inheritance.
  • Reduce the balance in the traditional IRA, which will in turn reduce subsequent taxable required minimum distributions.
  • Get the money to the charity sooner.
  • Enjoy the appreciation of the charity during one's lifetime.
  • See how the contribution is put to use.

This technique can also be used by higher-income taxpayers to reduce or eliminate the new 3.8% Medicare surtax. If a married couple has $175,000 of earned income and $75,000 of investment income this year and must take a $50,000 RMD from their IRA, $50,000 will be subject to the new surtax. But if that couple elects to distribute the $50,000 IRA RMD directly to a charity, no income will be subject to the Medicare surtax. The couple will save $1,900!

Because the extension for tax year 2012 was not extended until January, the Act permits two special options. You can choose to treat an IRA distribution received in December as a tax-free transfer to a charity and not reportable on your 2012 Form 1040, if the money is transferred to a charity before Feb. 1. Or you can treat distributions made from an IRA to a charity in January as being made in December, allowing up to $200,000 to be transferred during this calendar year.

By the way, the direct, tax-free transfer to a charity is not available from SEPs or Simple IRAs.
Robert Flach has more than 40 years of experience as a tax professional and also blogs as The Wandering Tax Pro.

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