Take-Away: Using retirement assets to satisfy an individual’s philanthopic objectives can be done in a tax-efficient way manner. Especially with a qualified charitable distribution (QCD.) However, you just have to know the rules.

Background: It is that time in the calendar year when individuals start to think about charitable giving, and/or reducing their income tax liability for 2021 through charitable gifts. When an individual receives a taxable distribution from a retirement account like an IRA and subsequently donates the distribution proceeds to charity, a charitable income tax deduction can be claimed as an itemized deduction. But not too many taxpayers itemize their income tax deductions these days in light of the ‘doubled’ standard deduction and the SALT limitation of $10,000.

Mismatch: Moreover, because an itemized income tax deduction does not reduce adjusted gross income (AGI), claiming a charitable income tax deduction might not result in a full and complete offset of the income tax that is generated by the taxable distribution that preceded and funded the charitable donation. In short, a mismatch results.

Qualified Charitable Distribution. This opportunity provided by the Tax Code helps some individuals to avoid the mismatch just described. [IRC 408(d).]

QCD Rules:  Recall that a qualified charitable distribution, or QCD, can only be made: (i) if the donor is over the age of 70 1/2 at the time the QCD is made; (ii) the QCD is only made directly to a 501(c)(3) tax exempt entity, excluding private foundations and donor advised funds (DAFs); (iii) from an IRA. The QCD may be up to $100,000 per year from the donor’s IRA (and all the donor’s IRAs are aggregated for this purpose.) If these rules are complied with, no amount of the QCD is reported as income by the donor and no income tax charitable deduction is claimed by the donor.

DAF: If a direct distribution is made to a donor advised fund (DAF) it will not qualify as a QCD. That distribution will have to be reported as taxable income of the donor, but the donor may also claim the contribution as part of the donor’s itemized income tax deductions for the year. [IRC 408(d)(8)(B)(i).]

Qualified Plans: Nor will a direct distribution from the owner’s qualified plan account, e.g. 401(k) or profit sharing account, qualify as a QCD. However, if the qualified plan permits, funds can be transferred from the qualified plan to an IRA owned by the plan participant, and funds can then be directly transferred from the IRA as a  QCD to the designated charity. Note, however, that no portion of a required minimum distribution (RMD) of the transferor-participant under the qualified plan is satisfied by a QCD made from the transferee-participant’s IRA.

Inherited IRAs: Funds held in an inherited IRA can be distributed as a QCD, but only so long as the designated beneficiary has attained age 70 1/2 prior to the QCD. [IRS Notice 2007-7, A-37.]

Recent IRA Contributions: To the extent that deductible IRA contributions were made in any of the 3 years preceding the year of the QCD, the gross income from the IRA distribution must be reported as gross income of the donor, but a charitable income tax deduction may also be claimed. [IRC 408(d)(8)(A).] This narrow rule places the individual donor in the same position as an IRA owner who receives a taxable IRA distribution and then contributes the proceeds to charity.

After-Tax Contributions: If the IRA owner has income tax basis in his/her IRA, a QCD will reduce basis to reflect that portion of the value of the QCD relative to the value of the IRA. [IRS Publication 590-B.] Because a distribution of nondeductible contributions from the IRA is made, the IRA owner must file Form 8606 to determine the amount to enter on line 4b of Form 1040-SR and the remaining basis in his/her IRA. In short, if the IRA owner has made a nondeduction contribution to his/her IRA, i.e. there is basis in the IRA, the basis portion cannot be a QCD, but it may instead be claimed as an itemized income tax charitable deduction by the donor. The nondeductible portion can be part of the donor’s itemized deductions, e.g. Schedule A (Form 1040) with Form 1040-SR, subject to the donor’s AGI limitations on what can be deducted, and what part of the charitable contribution must be carried over and used in future tax years.

Charitable Giving With Trusts: Consider an IRA owner who names an irrrevocable trust as his/her IRA designated beneficiary. The trust contains a charitable bequest, i.e. a pecuniary amount, such as “Upon my death the trustee shall distribute $50,000 to the American Red Cross for its general charitable purposes.” If the trustee satisfies this pecuniary bequest or legacy by transferring the decedent’s IRA to the American Red Cross that is made payable to the trust, that distribution will cause the trust to recognize taxable income, just as though the IRA had been distributed in full to the trust. That is because satisfaction of a pecuniary gift with property is treated as a sale or exchange of the property.

Income Recognition: The IRS’ position is that qualified retirement  assets used to fund a pecuniary bequest or legacy to a charitable organization will be considered an income recognition event, thus triggering ordinary income by the trust. [Chief Counsel Advisory 2006 44020.] That is because the “terms of the trust do not direct or require that the trustee pay the pecuniary legacy from the trust’s gross income.” 

No Charitable Deduction: Nor will the use of the IRA to satisfy a charitable legacy entitle the trustee to claim an income tax charitable deduction. [IRC 642(c)(1).] If the trust instrument, by its terms, does not require the charitable gift to be paid of  gross income, the charitable income tax deduction will not be available to the trust. In other words, if the IRA owner intends to name a trust as the designated beneficiary of the owner’s IRA at death, the terms of the trust instrument must require that charitable gifts provided for in the trust be paid from trust income in order for a charitable income tax deduction to be claimed by the trust. Alternatively, if the charitable gift is described in the trust instrument as a fractional share of the trust’s assets, then an in-kind distribution of the IRA to the charity by the trustee in satisfaction of its right to receive a fractional share of the trust’s assets also avoids recognition of gross income by the trust.

Conclusion: Using retirement assets to satisfy charitable bequests or legacies on death, or using retirement assets to obtain an income tax charitable deduction can be a highly tax efficient use of those assets. That said, the rules have to be carefully followed, especially with regard to QCDs, in order to make the most tax effective use of those retirement assets while avoiding a mismatch between the recognition of taxable income and the amount of the charitable income tax deduction that can be claimed.