INTRODUCTION

In 2017, approximately 61% of households held an individual retirement account (IRA) or other tax-deferred retirement plan and more than one-third of American households owned at least one type of IRA, according to the Investment Company Institute (ICI). The ICI estimated that by the end of 2017, Americans held $28.2 trillion in retirement assets, with $9.2 trillion retained in IRAs, making IRAs the largest pool of retirement type assets in the U.S.

Advisors may be able to maximize tax savings for their clients by advising them to consider making a qualified charitable distribution (QCD), commonly known as an IRA charitable rollover. Advisors armed with the knowledge of the tax benefits of an IRA charitable rollover can present their clients with a plan that maximizes their federal income and estate tax savings by using their IRA to make charitable gifts while fulfilling the clients' philanthropic goals.

This two-part article will explain some basic rules surrounding IRA charitable rollovers. This article will discuss the rules applicable to IRA charitable rollovers, address some frequently asked questions and illustrate common scenarios in which a QCD may maximize a donor's benefits. This article will also touch on pending legislation regarding the expansion of the IRA charitable rollover.

Part two of this series will discuss tax implications for the ultimate distribution of an IRA to loved ones. The second article will explore using a testamentary charitable remainder unitrust as a tax-efficient option for distributing an IRA to beneficiaries. Advisors who have a firm understanding of charitable IRA solutions will be better equipped to meet their clients' goals.

IRA CHARITABLE ROLLOVER BASICS

The IRA charitable rollover, or QCD, allows IRA owners age 70½ and older to make tax-free transfers of up to $100,000 each year directly from an IRA to a qualified charity without taking the distribution as taxable income. Sec. 408(d)(8)(A). Because the distribution is not taxable to the donor, he or she will not be allowed to take a charitable deduction. For married taxpayers, each individual IRA owner may transfer up to $100,000. The QCD amounts may come from multiple IRA accounts to equal an aggregate of $100,000 in distributions per taxpayer. The same rules apply to inherited IRAs where the beneficiary of the inherited IRA has reached age 70½. Notice 2007-7, Q&A-37.

Beginning at age 70½, IRA owners must take required minimum distributions (RMDs) from their IRAs. The RMD is calculated using the IRA owner's life expectancy under the Uniform Table and the IRA fair market value on December 31 of the prior year. Distributions start at age 71 at approximately 3.8% of the IRA balance and increase each year.

Generally, the RMD must be distributed by December 31 each year. IRA owners who fail to take their RMD will be subject to a 50% penalty tax. To avoid taking the RMD into income, IRA owners can satisfy their RMDs (up to $100,000) by making IRA charitable rollover gifts to qualified charities. An IRA owner who wishes to satisfy his or her RMD with a QCD should work with their IRA custodian to ensure that the charity actually receives the distribution before December 31 to avoid any penalty tax assessments.

Example 1

Jackson spoke with his financial advisor Erica regarding his RMD for the year. Jackson mentioned that he usually waits until the end of the year to take his RMD because he does not need it to cover his daily expenses. Erica suggested that he use the RMD to make his charitable gifts this year since she knows that Jackson supports a number of local charities.

Jackson is thrilled with that idea. He was already planning on making additional year-end charitable gifts totaling $50,000. His RMD on his IRA is approximately $40,000. Jackson is able to use the QCD to satisfy his RMD, reduce his taxes and fulfill his charitable goals for the year with the $50,000 tax-free transfer from his IRA.

Other Retirement Plans

The IRA charitable rollover only applies to funds transferred directly from the IRA to the charity. The transfer is usually made from a traditional IRA. However, donors may have 403(b), 401(k) or other retirement accounts. Those plans are not eligible for the IRA charitable rollover. Donors holding other qualified retirement accounts should discuss converting the accounts to IRAs with their advisors. Once the retirement account is rolled over to an IRA, the client can then benefit from the IRA charitable rollover.

Advisors are in a unique position to counsel and guide clients on how to convert a nonqualified retirement plan into an IRA. Clients may then make tax-free IRA charitable rollover gifts to more readily reach their philanthropic goals, reduce their taxes and enjoy financial security in retirement.

Generally, a taxpayer may roll over a non-qualified retirement plan into a qualified IRA. Typically, the conversion is made tax free. Once the client has converted the nonqualified retirement plan, he or she can make QCDs to qualified charities from an eligible IRA.

Example 2

Georgia is a retired professor. Her 403(b) retirement account has grown substantially over the course of her academic career. She recently turned 71 and vaguely remembers hearing about the possibility of using her retirement accounts to make charitable gifts. She heard this method was better for non-itemizing taxpayers, such as herself. She checked with her financial advisor to see if she could make a tax-free transfer directly from her 403(b) to the university. Georgia learned that she could only make tax-free charitable rollover gifts from an IRA. However, her financial advisor mentioned that her 403(b) account could be converted tax free to an IRA, which would then allow for QCDs. Georgia thought this was a great idea and decided to convert her 403(b) account into an IRA.

Georgia was overjoyed that she could now make QCDs to the university. Georgia receives the benefit of tax-free transfers of her RMD to charity. Her RMD is not included in her income if she makes a QCD and she is able to continue making charitable gifts.

Transfer Requirements

An IRA charitable rollover must be made directly to a qualified charity in order for the IRA owner to take advantage of the tax-free treatment. The IRA custodian may rely on reasonable representations by the IRA owner that the QCD is directed to a qualified charity. A QCD is treated as electing out of tax withholding under Sec. 3405(a)(2). Thus, the entire amount of the QCD is distributed to charity.

Only qualified charities are permitted to receive QCDs. Qualified charities are defined in Sec 509(a)(1) and Sec. 170(b)(1)(A) as public charities and conduit foundations. Donor advised funds as defined in Sec. 4966(d)(2) and Sec. 509(a)(3) supporting organizations are not considered qualified charities. Sec. 408(d)(8)(B)(i). A private foundation is excluded from receiving QCDs, unless it is a private-operating foundation or a conduit (pass-through) private foundation.

Typically, the IRA custodian will transfer the funds directly to the qualified charity. A donor may deliver a check from the IRA if it is made payable to the charity. This QCD will retain its tax-free distribution characteristic because it is considered a direct payment from the IRA trustee to the charity for purposes of Sec. 408(d)(8)(B)(i). Notice 2007-7, Q&A-41. The donor cannot, however, receive a check that is made payable to himself or herself and then make a QCD. The check from the IRA custodian must be made payable to the charitable organization.

A donor may satisfy all or a portion of his or her RMD using an IRA charitable rollover, up to the $100,000 limit. An amount in excess of the RMD may also be used to make an IRA charitable rollover up to $100,000. The IRA charitable rollover amounts distributed to charity are not taxable. However, any amount the IRA owner receives from an IRA will be taxable.

No "Quid Pro Quo"

If the IRA owner makes a QCD, he or she may not receive any excess goods, services or benefits from the charitable organization receiving the QCD. If any part of the QCD amount is a "quid pro quo" transfer, the entire distribution becomes taxable to the IRA owner. For example, the QCD cannot be used to pay membership dues or for a table at a charity's gala. If a donor uses a portion of the QCD for a non-deductible purpose, such as preferential seating at an event, the donor will be taxed on the entire QCD amount. However, an IRA charitable rollover can be used to satisfy a legally-binding pledge on behalf of the donor. Notice 2007-7, Q&A-44.

Example 3

Jackson mentions to his financial advisor Erica that he usually receives tickets to a charity's annual gala for an annual $2,000 donation. Jackson asks Erica whether he can use his QCD to make the $2,000 donation and receive the gala tickets, because he would be donating $1,800 if he excludes the value of the two gala tickets. Erica cautions that if a QCD is used for that donation and he receives the gala tickets, the entire amount of the donation will not qualify for QCD treatment. If Jackson makes this donation, he will be taxed on the full $2,000 distribution from his IRA.

Substantiation Requirements

IRA owners are subject to the same substantiation requirements for QCDs as for tax deductible gifts under Sec. 170(f)(8)(B). Sec. 408(d)(8)(E). However, receipts from charities for QCDs should be substantially different than receipts for tax deductible donations. The charity's gift acknowledgement should include the date of the gift, the IRA custodian's name, the amount of the gift, that the gift is a qualified charitable distribution under Sec. 408(d)(8)(A) and that no goods or services were provided in exchange for the gift. The gift acknowledgement should provide assurance that the charity is a Sec. 170(b)(1)(A) public charity and the gift is not made to a Sec. 509(a)(3) supporting organization or a Sec. 4966(d)(2) donor advised fund. The receipt may also state whether the gift is for a general purpose or a field of interest fund.

HISTORY OF THE IRA CHARITABLE ROLLOVER

The Pension Protection Act of 2006 introduced the IRA charitable rollover as a temporary provision that was set to expire December 31, 2007. Congress, however, extended or reintroduced the provision each year until it was made permanent in 2015. In some years, the extension was passed retroactively after the fiscal year had ended. This made IRA tax planning difficult for IRA owners.

The Protecting Americans from Tax Hikes (PATH) Act of 2015 was signed into law on December 18, 2015. The provision allows IRA owners age 70½ or older to make direct transfers from their IRA to charity of up to $100,000 each year. The IRA charitable rollover is not included in the donor's adjusted gross income and may satisfy the IRA owner's required minimum distribution (RMD). Sec. 408(d)(8)(A).

In late 2017, Congress passed the Tax Cuts and Jobs Act, which nearly doubled the standard deduction amount. Due to the increased standard deduction, many taxpayers may no longer itemize their deductions and instead may choose to take the standard deduction.

One of the attractive elements of the IRA charitable rollover is that taxpayers, regardless of their itemizing status, may benefit from making qualified charitable distributions. Non-itemizing taxpayers can exclude the amount of the IRA charitable rollover from their income, effectively reducing their tax bill in the same way they would if they claimed an itemized charitable deduction. The IRA charitable rollover is sometimes referred to as a "universal deduction," because it can benefit non-itemizers and itemizers alike.

Taxpayers who do itemize are able to maximize their charitable deductions up to the adjusted gross income (AGI) limitations. For cash gifts, a donor may deduct up to 60% of his or her AGI. For appreciated property gifts, a donor can offset up to 30% of their AGI if itemizing his or her charitable deductions. The IRA charitable rollover is not subject to the AGI limits on charitable deductions. Therefore, donors are able to use the IRA charitable rollover to give over and above their AGI limitations.

It is important to note that the IRA charitable rollover is a federal tax law. States are not required to adopt the same tax laws or planning strategies. There may be some states that do not recognize the IRA charitable rollover. In those states, IRA owners may still be taxed on the IRA charitable rollover amount and may instead receive a charitable deduction for the amount of the distribution. Thus, it is important that advisors to be aware of differing state treatment of IRA charitable rollovers.

FUTURE OF THE IRA CHARITABLE ROLLOVER

Following the passage of the PATH Act in 2015, other bills have been introduced in Congress with the intent of expanding the reach of the IRA charitable rollover. One pending bill addresses the expansion of the IRA charitable rollover to life income gifts.

The Legacy IRA Act

The Legacy IRA Act, H.R. 1337, was introduced to the House of Representatives on March 2, 2017. The bill was referred to the House Committee on Ways and Means on the same day. Many charitable organizations are hopeful the Legacy IRA Act will become law in the very near future and have voiced their support for the Legacy IRA Act.

The Legacy IRA Act would expand IRA charitable rollovers to allow distributions from IRAs to life income split-interest gifts for IRA owners age 65 or older. The Legacy IRA Act would allow IRA owners to transfer up to $400,000 to split-interest gifts, such as charitable remainder unitrusts and charitable gift annuities, each year. The Legacy IRA Act would leave the QCD rules under the PATH Act unchanged. QCDs of up to $100,000 would continue to be permitted for IRA owners age 70½ and older. In cases where the IRA owner would make both a transfer to a split-interest gift and a charitable rollover, the total combined annual limit would be $400,000, with outright IRA charitable rollovers capped at $100,000.

Example 4

Dominique, age 75, has been making charitable gifts using the current IRA charitable rollover for the past few years to satisfy her RMDs. She enjoys the ease and convenience of using her IRA to make gifts to charity. Dominique likes to make charitable gifts up to her AGI limits each year. Thus, the IRA charitable rollover is a very tax-efficient strategy for her. Ethan, a gift planner at Dominique's favorite charity, has been speaking with her about the potential changes under the Legacy IRA Act. Ethan mentioned that if the Legacy IRA Act becomes law, Dominique would be able to do much more with her IRA. Ethan explains that under the Legacy IRA Act, she would be able to continue making IRA rollovers in the amount of $100,000, and also make an additional gift to a charitable remainder unitrust or charitable gift annuity up to $300,000. Dominique is enthusiastic and supports passage of the Legacy IRA Act. She called her representatives and senators to express her support for the bill.

If signed into law, the Legacy IRA Act would approve IRA gifts to charitable remainder unitrusts, charitable remainder annuity trusts and charitable gift annuities. The transfers would not produce charitable deductions, but the amounts transferred up to $400,000 would be excluded from the donor's AGI. The donor's life income interest would not be assignable, not even back to the charity. The minimum payout percentage for these life-income gifts would be 5%, including charitable gift annuity payouts.

Charitable remainder unitrusts would be required to utilize the standard payout method. Thus, charitable remainder unitrusts could not be structured as FLIP CRUTS, NICRUTS or NIMCRUTS. Multiple contributions would be permitted to charitable remainder unitrusts, but all contributions would have to be IRA charitable transfers. Deferred payment gift annuities would not be permitted. All income payments from the charitable gift annuity would be characterized as ordinary income.

Example 5

James has been keeping up with current charitable legislation. He is very hopeful that the Legacy IRA Act will become law. James is 68, so he is not yet eligible to make IRA charitable rollovers. James has asked his gift planner, Tammy, to prepare an illustration for a $400,000 gift annuity. He would like to make the gift from his IRA if the Legacy IRA Act is signed into law. Tammy emphasizes that the Legacy IRA Act is not current law. She prepares an illustration showing what James' gift could look like if the Legacy IRA Act is signed into law. If that were the case, James would not receive a charitable deduction. Instead, he would simply report the amount as non-taxable distributions from his IRA on his tax return. His annuity payments would be taxed as ordinary income. James would receive a 5.3% annuity payment of $21,200 for his life. James continues to support the passage of the Legacy IRA Act and hopes to be able to use his IRA for a tax-free transfer to fund a charitable gift annuity.

Since the bill's introduction, it has garnered support from many charitable and tax-exempt organizations. There is hope that the Legacy IRA Act will be included in future tax reform legislation.

CONCLUSION

IRAs are the largest pool of retirement assets in the U.S. and the number of IRAs in existence continues to grow each year. As more clients reach age 70½, the IRA charitable rollover becomes an increasingly more common way of meeting the charitable goals of clients in a tax-efficient manner. By understanding the basic rules regarding IRA charitable rollovers, the tax benefits and pending future legislation, advisors can provide clients with solutions that will meet their personal and financial objectives.