A Narrow Planning Tip

Take-Away: In order to save state income taxes, make a qualified charitable distribution from an inherited IRA, if one is available.

Background: An inherited traditional IRA, or an inherited Roth IRA, can be the source of a qualified charitable distribution (QCD). The QCD will be reported as a death distribution. And like a QCD from the owner’s own IRA, itemization of the distribution will not be required in order to make the QCD. Again, like the owner’s own QCD, the QCD amount distributed from the inherited IRA is not taxed to the inheritor, but the inheritor will not be eligible to claim the distribution as a charitable income tax deduction. Nor will the QCD from the inherited IRA  be subject to income taxation.  But, like the owner’s own QCD, the inheritor must also be over the age of 70 ½ before the QCD can occur from the inherited IRA. [IRS Notice 2007-7, Q&A- 37.]

Question: Suppose an individual owns their own traditional IRA and they also own an inherited an IRA from a deceased parent or other relative. If the inheritor is over the age of 70 ½ and wishes to implement their charitable giving by making QCDs, what is the better source from which to make the QCD? Their own traditional IRA, or their inherited IRA?

Answer: Make the QCD from the inherited IRA, for state income tax reporting purposes.

Reasoning: In Michigan, if the recipient of the inherited IRA was born before 1946, he/she may subtract from their reportable taxable income all qualifying retirement income and pension benefits from public sources, and he/she may subtract private retirement and pension benefits up to $108,808 from their taxable income. [Form 4884, Michigan Pension Schedule.] However, for an inherited IRA distribution to qualify for a subtraction from income for Michigan income tax reporting purposes, the beneficiary-inheritor must be the surviving spouse. Form 1099-R Distribution Codes provide for the deduction [subtraction from income] on the death of the IRA owner but only for a surviving spouse.

“Yes, for surviving spouse only and only if the decedent has also qualified for a normal distribution under Distribution Code 7 at the time of death. No, for all other beneficiaries.”

Thus, in order to claim a Michigan income tax deduction [or, subtraction from gross income] for retirement benefits, those benefits must be included in the individual’s reported federal adjusted gross income. Therefore, for an inherited IRA distribution to qualify as a reduction in [subtraction from]the inheritor’s gross income, the inheritor must be the surviving spouse of the deceased IRA owner. If the inheritor is not the surviving spouse of the deceased IRA owner, then there is no subtraction from reported income for Michigan income tax calculation purposes. Making the QCD from the inherited IRA preserves the reduction on the Michigan income tax return for the RMD that the IRA owner must take from his or her own IRA, where if the QCD came from the owner’s own traditional IRA, that would cause the donor to lose the benefit of the state deduction [subtraction] from reportable gross income.

Conclusion: Admittedly this is a narrow planning opportunity when dealing with QCDs. But if there is a choice of sources from which to make a QCD, it is probably better to use the inherited IRA as the source to make QCDs, thus permitting the inheritor’s own RMD to reduce their taxable income for state income tax reporting purposes.