Tag Archives: Required Minimum Distributions

Excess Contributions to an IRA

There are limits to how much can be contributed to traditional IRAs and Roth IRAs. This post describes how excess contributions happen and how to resolve them.

Three introductory notes. First, if you find that you have made an excess contribution, you may be well advised to seek professional advice. Second, please don’t panic, but make sure to act swiftly. Excess contributions are resolvable but do not benefit from delays. Third, you should not plan to make an excess contribution for a variety of reasons.

Traditional IRAs

There are (generally speaking) three situations that generate an excess contribution to a traditional IRA. They are:

Contributions are made for a year the taxpayer (and their spouse) does not have earned income.
Contributions are made in excess of the annual contribution limits.
Rolling into an IRA an amount that did not qualify to be rolled in.

This last category is not immediately obvious, but it does occasionally occur. For example, a taxpayer might inherit a taxable account and incorrectly roll it into an inherited IRA. Or a taxpayer might incorrectly roll an IRA they inherited into their own IRA. Or a taxpayer might attempt a 60-day rollover of amounts previously in an IRA and roll the money into an IRA after the 60-day deadline. Note that in some cases, this last mistake can be resolved by obtaining a private letter ruling from the IRS (doing so is beyond the scope of this post).

For 2019 and prior taxable years, there is an additional category: contributions to a traditional IRA when the taxpayer was 70 1/2 or older. The SECURE Act eliminates the prohibition on those 70 1/2 and older contributing to a traditional IRA.

Resolutions

Recharacterization

Prior to the 2020 tax year, if you qualified to make a contribution to a Roth IRA, but not to a traditional IRA, you could direct your financial institution to recharacterize the contribution to a Roth IRA. This scenario only applied in situations where the taxpayer was over age 70 ½ when the contribution was made to the traditional IRA.

Now there is no scenario where this would be relevant. Anyone not qualifying to make a contribution to a traditional IRA would also not qualify to make a contribution to a Roth IRA.

However, recharacterizations of contributions from traditional IRAs to Roth IRAs can make sense for some taxpayers for tax planning reasons, and are allowable if done properly.

To recharacterize, you must contact the financial institution and direct them to move the contribution and its earnings to a Roth IRA. This must be disclosed in a white paper statement attached to your federal income tax return. The recharacterization deadline is the extended due date of the tax return (generally October 15th).

Withdrawal

A second way to correct an excess contribution to a traditional IRA is to take a “corrective distribution” of the excess contribution and its earnings from the IRA. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. If the excess contribution is withdrawn prior to the extended filing deadline, the withdrawal of the contribution itself is generally not included in taxable income.

As observed in IRS Publication 590-A, page 34, in most cases the financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. For example, if a 2023 IRA contribution is made in January 2024, and the taxpayer later takes a corrective distribution of that contribution and its earnings, the earnings will be includible in taxable income in 2024. In those cases where the taxpayer must compute the earnings, IRS Publication 590-A Worksheet 1-3 is a resource for figuring the earnings or loss.

See Example 1 in this article for insights on the reporting timing of earnings attributable to corrective distributions.

Up until the passage of SECURE 2.0, the earnings were also subject to the ten percent early withdrawal penalty (unless an exception otherwise applied). However, SECURE 2.0 Section 333 repealed the early withdrawal penalty with respect to withdrawals of earnings occurring pursuant to a corrective distribution. Note further that as of March 1, 2024 there is now some doubt as to the on going validity of SECURE 2.0.

A quick note on corrective distributions (as applied to both traditional IRAs and Roth IRAs): they can be done if the taxpayer has changed their mind. Natalie Choate makes this point in her excellent treatise Life and Death Planning for Retirement Benefits (8th ed. 2019, see page 132). Corrective distributions are not limited to simply those times when the taxpayer has made a contribution in excess of the allowed limits.

Apply the Contribution to a Later Year

You can keep an excess contribution in a traditional IRA and apply it to a later year, if you are eligible to make a traditional IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual IRA contribution limit.

Penalties

If you do not resolve the excess contribution prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn from the traditional IRA. You report and pay the excise tax by filing a Form 5329 with the IRS. Because this six percent tax is imposed each year the excess contribution stays in the traditional IRA, it is important to correct excess contributions to traditional IRAs promptly.

Note further that excess contributions withdrawn after the extended filing deadline are generally included in taxable income, though the taxpayer can recover a portion of any IRA basis they have under the Pro-Rata Rule.

Roth IRAs

There are (generally speaking) four situations that cause an excess contribution to a Roth IRA. They are:

Contributions are made for a year the taxpayer (and their spouse) does not have earned income.
Contributions are made in excess of the annual contribution limits.
Contributions are made for a year the taxpayer exceeds the modified adjusted gross income (“MAGI”) limitations to make a Roth IRA contribution)
Rolling into a Roth IRA an amount that did not qualify to be rolled in.

A rather common excess contribution occurs when taxpayers contribute to a Roth IRA in a year they earn in excess of the MAGI limits. That can happen for a host of reasons, including end of year bonuses or other unanticipated income.

Another somewhat common mistake in this regard is made by those subject to required minimum distributions (“RMDs”) when trying to convert traditional IRAs to Roth IRAs. In early January a taxpayer might convert a chunk of their traditional IRA to a Roth IRA. This creates a problem if the taxpayer did not previously take out their annual RMD for the year. There is a rule providing that RMDs are the first money to come out of an IRA during the year, and RMDs may not be converted to Roth IRAs. Thus, “converting” the first dollars out of a traditional IRA (an RMD) during the year creates an excess contribution to a Roth IRA.

Resolutions

Recharacterization

Assuming that the taxpayer qualifies to make a contribution to a traditional IRA, the excess contribution to a Roth IRA can be recharacterized as a contribution to a traditional IRA. Generally, the taxpayer must contact the financial institution and direct them to recharacterize the contribution and its earnings into a traditional IRA and must file a white paper statement with their tax return explaining the recharacterization.

When the taxpayer’s income puts him or her over the Roth IRA MAGI limits, recharacterization is often how excess contributions to Roth IRAs are resolved. In such cases, they will generally qualify to make a contribution to a traditional IRA, so a recharacterization is often the go-to method of correcting an excess contribution to a Roth IRA.

Note that the recharacterization deadline is the extended due date of the tax return (usually October 15th).

Withdrawal

A second way to correct an excess contribution to a Roth IRA is to take a corrective distribution of the excess contribution. You will need to inform your financial institution of the excess contribution and request a corrective distribution of the excess contribution and the earnings attributable to the excess contribution. The withdrawal of the excess contribution itself is generally not taxable.

The financial institution will compute the earnings attributable to the excess contribution. The earnings will be included in taxable income for the actual year the excess contribution was made. The same inclusion timing rules applicable to traditional IRA corrective distributions (discussed above) apply to the earnings from a Roth IRA corrective distribution.

If the corrective distribution occurs after the taxpayer files their tax return for the relevant taxable year, but before the extended filing deadline for the year (generally October 15th), the taxpayer must file an amended return which reports the corrective distribution and includes the earnings in taxable income (if the original contribution actually occurred in the year covered by the tax return).

Apply the Contribution to a Later Year

As with excess contributions to traditional IRAs, you can keep an excess contribution in a Roth IRA and apply it to a later year, if you are eligible to make a Roth IRA contribution in that later year. This method does not avoid the six percent penalty discussed below for the year of the contribution, but it allows the taxpayer to avoid taking a distribution of the excess contribution and stops additional impositions of the six percent excess contribution penalty. Generally, this method is only effective if the amount of the excess contribution is relatively modest, since a large excess contribution cannot be soaked up by only one year’s annual Roth IRA contribution limit.

Penalties

As with excess contributions to traditional IRAs, if you do not resolve the excess contribution to your Roth IRA prior to the extended deadline for filing your tax return, you must pay a six percent excise tax on the excess contribution annually until the excess contribution is withdrawn. It is best to resolve an excess contribution to a Roth IRA sooner rather than later to avoid annual impositions of the penalty.

Tax Return Considerations

Corrective measures applied to traditional IRA and/or Roth IRA contributions may require tax return reporting. Such reporting is discussed in various sources. Examples of such sources include IRS Publication 590-A, the Instructions to the Form 8606, and/or the Instructions to the Form 5329.

Conclusion

Excess contributions to IRAs and Roth IRAs happen. They are not an occasion to panic. They are an occasion for prompt, well considered action. Hopefully this article provides enough background for you to start your decision process and, if necessary, have an informed conversation with a competent tax professional.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Tax Efficient Estate Planning

THIS POST HAS NOT BEEN UPDATED FOR THE SECURE ACT, WHICH WAS ENACTED IN LATE 2019.

If you have significant assets, you need an estate plan. A good estate plan makes handling the financial aspects of your death much easier for your loved ones and creates the opportunity for multiple generation wealth creation.

For most, the need for good estate plan is not about the estate tax. Very few Americans, particularly very few actively seeking financial independence, will be subject to the federal estate tax, as there is now (as of 2019) a $11.4 million estate tax exemption. Thus, only the very largest of estates will pay the federal estate tax. For purposes of this post, assume that all estates are below this threshold.

If you are aren’t subject to the estate tax, why do you need to make a tax efficient estate plan? The answer is the income tax considerations of your heirs and beneficiaries. Some assets cause your heirs and beneficiaries to have very little or no additional income tax. Other assets can cause a significant increase in the income tax burdens of your heirs and beneficiaries. Below I analyze each of the tax baskets and discuss the estate planning considerations for each one.

Being that the FI community generally aims to build up significant assets to achieve financial independence, good estate planning is particularly important if you are on the road to (or have achieved) financial independence.

A quick caveat at the beginning – tax is only one consideration in estate planning. There are many others, including the needs of spouses, children, and other potential heirs, and the desires of the donor. Below I offer thoughts on tax optimal estate planning — of course the tax considerations need to be balanced with other estate planning objectives.

Spouses

A quick note on leaving assets to spouses. Generally speaking, the tax laws favor leaving assets to spouses. A spouse is a tax-preferred heir in most situations (the main exception being leaving retirement accounts to younger beneficiaries with low RMDs). As the focus of this post is passing wealth to the second generation efficiently, most of the discussion, other than a few asides, will not address the tax consequences when leaving an asset to a spouse.

Tax Baskets

Below are the four main tax baskets (tax categories in which individuals can hold assets):

Traditional (a/k/a Deductible) Retirement Accounts: These include workplace plans such as the 401(k), the 403(b), the 457, and the TSP, and IRAs. Under ideal conditions, the contributions, when earned, are not taxed but the contributions and earnings are taxed when later withdrawn.
Roth Retirement Accounts: These include workplace plans such as the Roth 401(k), the Roth 403(b), and the Roth TSP, and Roth IRAs. Under ideal conditions, the contributions, when earned, are taxed but the contributions and earnings are tax-free when later withdrawn.
Health Savings Accounts: HSAs are tax-advantaged accounts only available to you if you have a high deductible health plan (a “HDHP”) as your health insurance. Under ideal conditions, the contributions, when earned, are not taxed and the contributions and earnings are tax-free when later withdrawn.
Taxable Accounts: Holding financial assets in your own name or otherwise not in a tax-advantaged account (tax baskets 1 through 3). The basic concept is taxable in, taxable on “realized” earnings (rental income, business income, dividends, interest, etc.) while in the account, and partially taxable (value less “tax basis”) on the way out.

Baskets 1 through 3 require “ideal conditions” (i.e., compliance with the related tax rules) to operate as outlined above. Let’s assume for purposes of this post that no errors are made with respect to the account in question.

Traditional Accounts

Of the four tax baskets, traditional accounts are often (from a tax perspective) the worst kind to leave to a spouse and the third worst to leave to non-spouse heirs. Why? Because traditional accounts, through required minimum distributions (“RMDs”), are eventually going to be entirely taxable to your beneficiaries and/or their beneficiaries. Non-spouse beneficiaries generally must take RMDs in the year following the donor’s death.

When passing traditional accounts to the next generation(s), a general rule of thumb is younger beneficiaries are better for such accounts, because the younger the beneficiary, the smaller their earlier RMDs, and thus the lower the tax hit of the RMD and the longer the tax-deferred growth.

Spousal beneficiaries, unlike non-spouse beneficiaries, have the option to delay RMDs until the year they turn 70 ½. However, once they turn 70 ½ they will be required to take taxable RMDs, increasing their taxable income.

For charitably inclined, traditional accounts (or portions thereof) are a great asset to leave to charity. As you will see, your individual beneficiaries would prefer to inherit Roth accounts (and in most cases will prefer to inherit taxable accounts), but the charity is generally indifferent to the tax basket of an asset, because charities pay no income tax. So all other things being equal, if you have money in traditional accounts, Roth accounts, and taxable accounts, the first money you should leave to a charity should be from your traditional accounts.

Lastly, whatever your plans, you are well advised to ensure that all your traditional, Roth, and HSA accounts have valid beneficiary designation forms on file with the employer plan or financial institution.

Roth Accounts

Roth accounts are fantastic accounts to inherit for both spouses and non-spouses. While non-spouses must take RMDs from the inherited Roth account in the year following death, the RMD is non-taxable to them. All beneficiaries benefit from tax-free growth of assets while they are in an inherited Roth account. This makes spouses (able to defer RMDs until age 70 ½) and younger beneficiaries ideal (from a tax perspective) to inherit Roth accounts.

Roth conversions are a potential strategy to save your heirs income tax. If you believe your heirs will have a higher marginal income tax rate than you do, and you do not need the tax on the Roth conversion, you can convert amounts in traditional accounts to Roth accounts, pay the tax, and lower the overall tax burden incurred by you and your family.

Health Savings Accounts

There are two, and only two, ideal people to leave an HSA to – your spouse or a charity. Spouses and charities are the only ones who do not pay tax immediately on an HSA in the year of death.

Unfortunately for non-spouse, non-charity beneficiaries, the entire account becomes taxable income to the beneficiary in the year of death and loses its status as an HSA. This can cause a significant one-time spike in marginal tax rates and cause the beneficiary to lose (to federal and state income taxes) a significant amount of the HSA. This makes the HSA the worst tax basket to leave to non-spouse, non-charitable beneficiaries.

Spouses are allowed to continue the HSA as their own HSA, and thus can use it to grow tax-free wealth that can cover (or reimburse) qualified medical expenses.

If you are charitably inclined and unmarried, the HSA should be the first account you consider leaving some or all of to charity.

Taxable Accounts

Taxable accounts, including real estate and securities, are generally good assets to leave to beneficiaries because of the so-called “step-up” in basis. As a general matter, when a person dies, their heirs inherit assets in taxable accounts with a “stepped-up” basis. This gives the heirs a basis of the fair market value of the property on the date of death.

As a result, a beneficiary can generally sell inherited assets shortly after receiving them and incur relatively little, if any, capital gains tax.

A couple of additional notes. First, leaving appreciated taxable assets at death to heirs is much better than gifting such assets to heirs during your life. A quick example: William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.

Second, the step-up in basis at death benefits spouses in both “common law” states and community property states. In all states, separately held property receives a full step up in basis when inherited by a spouse. For residents of common law states, jointly held property receives a half step-up – the deceased spouse’s portion is receives a step-up in basis while the surviving spouse’s half does not. For residents in community property states, the entirety of community property receives a full basis step-up at the death of one spouse.

Conclusion

Generally speaking, in most cases spouses will prefer to inherit assets in the following order:

Roth
HSA
Taxable
Traditional

In most cases, non-spouses will prefer to inherit assets in the following order:

Roth
Taxable
Traditional
HSA

The best two tax baskets to leave to charities are HSAs and traditional accounts.

You can obtain significant tax benefits for your heirs by being intentional regarding which tax baskets you leave to which beneficiaries. Some relatively simple estate planning can save your heirs a significant amount of federal and state income tax.

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.

Tax-Efficient Charitable Giving

Introduction

Charitable giving is fantastic! Why not give some of your assets to improve a part of our world? And while you’re at it, why not save a few bucks in income taxes? As is to be expected, this requires some thoughtfulness. For some people, this can drive significant tax savings.

Lay of the Land after Tax Reform

The December 2017 tax reform legislation (often referred to as “tax reform,” the Tax Cuts and Jobs Act, or “TCJA”) significantly altered the landscape for claiming itemized deductions. For 2017, before tax reform became effective, the standard deduction for single taxpayers was $6,350 and $12,700 for married filing joint (“MFJ”) taxpayers. Thus, in order to claim itemized deductions, the taxpayer’s total itemized deductions (such as mortgage interest, state and local taxes, and charitable contributions) had to exceed these thresholds for the 2017 tax year. Many itemized simply because their state tax withholding alone put them in a position to equal or exceed these thresholds. This matters with respect to charitable contributions because if you don’t itemize, you don’t get any tax benefit for your charitable contributions.

Post tax reform, things are different. First, tax reform significantly increased the standard deduction. In 2018 the standard deduction increased to $12,000 for single taxpayers and $24,000 for MFJ taxpayers. Second, the deductible amount of state and local taxes (including individual income and property taxes) is capped at $10,000 per tax return. Thus, for MFJ filers and who paid $10,000 or more in state and local taxes still need $14,001 more in itemized deductions (mostly mortgage interest and charitable contributions) to itemize.

Thus, many will now find that they will take the standard deduction instead of itemizing. The downside is losing the tax benefits of charitable contributions. However, there are several planning opportunities whereby taxpayers can still reap significant income tax benefits of charitable contributions.

Donor Advised Fund (“DAF”)

Ideal for: People (a) with standard deductions very close to their itemized deduction amount or greater and (b) who makes regular, predictable (weekly, monthly, quarterly, or yearly) donations to charities or plan to donate to charities in the future.

How it Works and Tax Benefits: A donor establishes a donor advised fund with a financial institution that has established a charitable institution for the purpose of managing donor advised funds. The donor provides assets to the DAF. Then the donor “advises the fund,” meaning that he or she requests that the fund make disbursements to particular charities in particular amounts. While the institution in control of the DAF could, theoretically, reject the request, as a practical matter as long as the requested charity is a valid, properly registered section 501(c)(3) public charity, the DAF will send money to the charity. There is no explicit time requirement for the DAF to disburse its funds, and thus the DAF can make donations to public charities for several years.

The DAF gives the donor a significant tax benefit in today’s high standard deduction environment. The donor receives an upfront tax deduction for the fair market value of the assets contributed to the DAF in the year of the contribution. It is a way for a donor to bring forward, for tax purposes, the charitable deduction for contributions to a charity or charities occurring over several years. For tax purposes, the DAF aggregates several years’ worth of charitable contributions in a single year without a future tax cost, since the donor is covered by the high standard deduction in the later years when the DAF contributes to the charities.

Example: Jane and Joe Smith attend Mass every Sunday at St. Joseph’s Catholic Church. Every time they attend Mass they put money in the collection basket as a charitable donation. In November 2018 Jane and Joe add up their projected 2018 itemized deductions (mortgage interest, state taxes, and charitable contributions) and project that they are at $24,000, exactly the same as the standard deduction. They anticipate their itemized deductions in 2019 will only be $18,000. If they make a $5,000 contribution to a DAF in early December 2018, their 2018 itemized deductions will increase to $29,000. Going forward until the DAF is exhausted, the DAF will make disbursements to St. Joseph’s instead of the Smiths making the contributions.

The contribution to the DAF provides the Smiths a significant tax benefit in 2018 ($5,000 reduction to taxable income) and will cost them nothing in 2019, since they will take the standard deduction for 2019 regardless. Forgoing 2019 tax deductions (by accelerating them to 2018 through the DAF contribution) did not cost Jane and Joe Smith any additional tax in 2019 and saved them tax in 2018.

If Jane and Joe were initially at $18,000 in 2018 itemized deductions instead of at $24,000, a $5,000 DAF contribution would not have made sense, because the Smiths would not have enough itemized deductions ($23,000) to exceed the standard deduction.

Another DAF tax benefit for the donor is that income earned by the DAF (i.e., interest, dividends, and capital gains) is not taxable to the donor. That income increases the charitable impact of the original DAF contribution.

Some caveats: First, a transfer to a donor advised fund is an irrevocable transfer. While the donor retains the right to advise the DAF regarding disbursements to charities, the donor cannot reclaim the funds for him or herself. Second, the institution holding the DAF will charge fees against the DAF assets. Finally, institutions usually require a minimum initial contribution in order to form a DAF.

Donation of Appreciated Stock

Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds.

How It Works and Tax Benefits: Donations of appreciated securities to an eligible charity allow the donor to deduct the entire FMV of the stock, up to 30% of adjusted gross income (“AGI”). Alternatively the donor can elect to deduct the basis of the stock, up to 60% of AGI. Further, the donor avoids recognizing the capital gain on the securities on his or her tax return. Thus, this strategy has a benefit from an income perspective (avoids recognition of a gain) and a benefit from a deduction perspective (the itemized charitable deduction).

For those looking to get rid of securities that no longer fit their desired investment portfolio, this can be a very tax efficient manner to do so.

Note that built-in loss securities should not be donated to charities. Rather, they should be sold first in order to trigger the capital loss for tax purposes, and then the proceeds should be donated to the charity.

Hyper Donor Advised Fund

Ideal for: Charitably inclined people owning appreciated stock, bonds, ETFs, or mutual funds that make routine charitable contributions or are interested in making future charitable contributions.

How It Works and Tax Benefits: The “hyper donor advised fund” (my pet name for this technique) simply combines the first two planning techniques.

Here is an example: Sammy owns 100 shares of Kramerica Industries. It is worth $50 per share ($5,000 total) and Sammy paid $5 per share ($500 total). Sammy has determined that he will have $11,000 of itemized deductions in 2018 and is likely to have no more than that in 2019 and 2020. Sammy plans to donate approximately $1,000 to his favorite charity, The Human Fund, annually.

Sammy can transfer the appreciated Kramerica stock to a DAF in December, 2018 and claim $16,000 of itemized deductions on his 2018 tax return without lowering his tax deductions in 2019 and 2020. Sammy also avoids recognizing on a tax return the $4,500 ($5,000 less $500 cost basis) gain he has in the Kramerica stock. The DAF can sell the Kramerica stock, invest the proceeds, and make, at Sammy’s recommendation, annual donations to The Human Fund.

Qualified Charitable Distribution (“QCD”)

Ideal for: (a) those 70 ½ or older and (b) those nearing age 70 ½ who cannot yet do a QCD, but should consider future QCDs when doing current tax planning.

How it Works and Tax Benefits: Donors 70 ½ years old and older can contribute up to $100,000 annually to charity directly from their traditional IRA without the amounts contributed being included in taxable income. The main advantage of this strategy is that the taxpayer’s “required minimum distribution” (“RMD”) can be satisfied by the QCD without a taxable income inclusion to the donor. While the donor does not receive a charitable deduction, that is made up for by excluding the amount of the QCD from taxable income. Given the new higher standard deduction, the taxpayer essentially gets the benefit of a charitable deduction without having to itemize.

While the QCD can satisfy the RMD, it does not have to – if a taxpayer has a RMD of $10,000 for the year but wants to make a $20,000 donation from their IRA to a charity, they can do so and the entire $20,000 amount qualifies for QCD treatment.

QCDs also present a planning opportunity for those not yet 70 ½ years old. Many do Roth Conversions (converting traditional IRAs and other traditional accounts to Roth IRAs) prior to age 70 ½ to reduce future RMDs. Doing so creates current taxable income, but lowers the future balance in the traditional IRA or 401(k) such that in the future RMDs are lower. For those charitably inclined, they may want to limit current Roth Conversions designed to mitigate future RMDs, since future QCDs can be used to eliminate the tax impact of RMDs in the future. Thus, charitably inclined individuals in their 60s may want to leave some amounts in traditional IRAs for future charitable donations. Then, when they turn 70 ½ they can make QCDs to avoid RMD taxable income.

It is important to note that to qualify for QCD treatment, the donor must be 70 ½ or older on the date of the distribution. Second, gifts to private foundations and DAFs do not qualify for QCD treatment. Third, inherited IRAs qualify for QCDs as long as the beneficiary inheriting the IRA is 70 ½ or older at the time of the distribution.

Lastly, the charity should never give any token gift of appreciation for the QCD donation because the receipt of anything in return for the donation disqualifies the distribution from favorable QCD tax treatment.

Bunching Contributions

Ideal for: Charitably inclined people with excess cash at year end.

How it Works and Tax Benefits: For taxpayers at or over the standard deduction threshold near year end, it may be advisable to make next year’s planned charitable donations this year to accelerate the tax deduction and take advantage of the next year’s higher standard deduction. Similar to some of the above techniques, the technique picks a year to itemize deduction and then picks a year (or years) to utilize the standard deduction in a manner the optimizes the total tax deductions taken over a period of time.

Charitable Remainder Trust

Ideal for: Wealthy charitably inclined people looking for a large current tax deduction, often in cases where they have a one-time significant income event, such as the sale of a significant asset or business or a very significant bonus.

How it Works and Tax Benefits: Taxpayers can contribute assets to a trust whereby the donor receives the income from the trust assets for a period of time and a designated charity receives the assets of the trust at the end of a period of years. This technique gives the donor a large upfront one-time deduction based on IRS rules.

This is generally not a strategy very applicable in the FI community, but for certain wealthy taxpayers looking for a significant tax deduction and willing to engage the right legal and tax professionals, it can create significant benefits.

Conclusion

Charitable giving illustrates the need to always consider whether there is a tax angle to a transaction. Contributions, if structured in particular way, can provide significant tax benefits while fulfilling their main purpose — the improvement of society and the advancement of the charity’s eleemosynary cause.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.