24-Feb-19
Qualified Charitable Distributions: Nondeductible IRA Contributions
Take-Away: While we are all familiar with the income tax benefits of a qualified charitable distribution from a traditional IRA, less clear is the implication of the IRA that holds non-deductible contributions. The after-tax portion of the IRA will not be treated as a qualified charitable distribution from the IRA.
Background: A qualified charitable distribution exclusion from income is limited to the qualified charitable distribution that would have been includible in the IRA owner’s taxable income, if the distribution had been made to that owner. Accordingly, if the traditional IRA contains non-deductiable contributions, meaning there is income tax ‘basis’ in the IRA, that ‘basis’ component will not qualify as a qualified charitable deduction. If the IRA contains ‘basis’ then a different set of rules will apply.
Ordering Rules: If the traditional IRA contains non-deductible contributions, the qualified charitable distribution will be treated as coming first from the untaxed portion of the IRA. Thereafter, from the portion of the IRA that was non-deductible. In short, when a qualified charitable distribution exceeds the untaxed portion of the IRA, the qualifed charitable distribution exclusion from income does not apply to the portion of the qualified charitable distribution that is deemed to come from the owner’s ‘basis’ in the IRA, as that portion would not have been included in the IRA owner’s taxable gross income.
Example: A traditional IRA owner, over the age 70 1/2, has an IRA balance of $100,000 of which $80,000 is pre-tax earnings, and the remaining $20,000 represents the owner’s non-deductible contributions to the IRA over the years, meaning that it the owner’s tax ‘basis’ in the IRA. A qualified charitable distribution is $85,000 is made (in satisfaction of an earlier charitable pledge by the IRA owner.) Thus, the amount is less than $100,000 which is the maximum amount that can be claimed a qualified charitable distribution by the IRA owner. The first $80,000 will be attributable to the untaxed portion of the IRA, with the balance of $5,000 treated as a recovery of the IRA owner’s ‘basis’ in the IRA. Because the $5,000 would normally not be included in the IRA owner’s gross income, qualified charitable distribution treatment will not apply to the $5,000. However, the IRA owner will be able to claim the $5,000 as a charitable income tax deduction, but subject to the normal limitations with respect to charitable income tax deductions, e.g. the donor’s income limitations or the possibility that the standard deduction will be larger resulting in no tax deduction for the $5,000.
Mulitiple IRA Permutations: Another complicating factor is if the donor has more than one traditional IRA. If there is more than one IRA, all IRAs, including Roth IRAs, are required to be treated as one collective IRA for the purpose of calculating the effect of a qualified charitable distribution where there is ‘basis’ in just one of the IRAs.
Roth IRAs: If you followed the reasoning above with respect to limiting the qualifed charitable distribution to amounts that would be includible in the IRA owner’s income, that would suggest that a qualified charitable distribution would not apply to Roth IRAs, since distributions from them are generally not includible in the owner’s taxable income. Yet the IRS, in Notice 2007-7 [2007-1 CB 395], expressly provides qualified charitable distribution treatment for distributions from a Roth IRA. [See, Question and Answer #36.]
Caveat: It would seem, however, the use of a Roth IRA to satisfy a charitable gift would be highly unusual, in light of the tax-free implications of distributions from a Roth IRA.
Example: One situation where a Roth IRA could be used as a source of funds for a qualifed charitable distribution would be if the Roth IRA had not yet been in existence for at least 5 years from its creation. Under that situation, distributions from the Roth IRA would still be taxable to its owner, and thus the Roth could be used instead as the source of the owner’s qualified charitable distribution.
Caution: Not every state recognizes the exclusion of a qualified charitable distribution from gross income. New Jersey has expressly refused to follow the federal exclusion of a qualified charitable distribution from taxable income. Other states, also looking for additional revenue, may decide to follow New Jersey’s lead, which would expose the qualified charitable distribution to state income taxation.
Conclusion: With the expanded taxpayer’s standard income tax deduction that resulted from the 2017 Tax Act, it is likely that we will see a lot more qualifed charitable distributions by older IRA owners, as the itemized charitable income tax deduction may no longer be available to them. By using the qualified charitable distribution in satisfaction of the IRA owner’s required minimum distribution obligation for the calendar year, it may also be possible to reduce the owner’s exposure to marginally higher federal income tax rates and the 3.8% Medicare surtax as well. As such it will be important to become familiar with all of the rules.