New year-end planning option for older taxpayers
 

Individuals who are at least age 70-1/2 and are considering charitable gifts as part of their year-end tax strategy have a new option to consider. For 2006 (as well as 2007), they can exclude up to $100,000 of otherwise taxable IRA (or Roth IRA) distributions that are paid directly to qualifying charitable organizations. However, excluded distributions can't be deducted as charitable contributions. This article takes a detailed look at how this new charitable giving option can benefit taxpayers.

Background. An individual taxpayer's deduction for contributions (other than contributions of appreciated capital gain property) may not exceed 50% of his contribution base (i.e., adjusted gross income (AGI), computed without regard to any net operating loss carryback) if made to a charitable organization (e.g., public charities, private foundations other than private non-operating foundations, and certain governmental units) or 30% of the contribution base if made to nonoperating private foundations. Contributions of appreciated capital gain property are deductible up to 30% of the taxpayer's contribution base if a special election is made.

For individual taxpayers, the total amount of certain itemized deductions (including charitable contributions) is reduced by the lesser of: (1) 3% of the taxpayer's AGI in excess of an inflation-adjusted threshold, or (2) 80% of the itemized deductions affected by the phaseout. For 2006, the AGI threshold is $150,500 ($75,250 for a married taxpayer filing a separate return). However, under an EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001) change that first applies in 2006, a taxpayer will lose only 2/3 of the amount he would otherwise lose under the regular reduction computation. Similarly, personal exemptions are phased out by 2% for each $2,500 ($1,250 for married taxpayers filing separately) or fraction of that amount by which AGI exceeds certain threshold amounts (e.g., $150,500 for unmarried individuals). Under EGTRRA, for 2006, a taxpayer will lose only 2/3 of the amount he would otherwise lose under the regular phaseout computation.

Limited window of opportunity. For distributions in tax years beginning in 2006 and 2007, an up-to-$100,000 annual exclusion from gross income is available for otherwise taxable IRA distributions that are qualified charitable distributions, as defined below. Such distributions aren't subject to the charitable contribution percentage limits since they will neither be included in gross income nor claimed as a deduction on the taxpayer's return. Because such a distribution is not includible in gross income, it will not increase AGI for purposes of the phaseout of itemized deductions, personal exemptions, or any other deduction, exclusion, or tax credit that is limited or lost completely when AGI reaches certain specified levels.

A qualified charitable distribution is one made, after the IRA owner attains age 70-1/2, directly by the IRA trustee to a charitable organization (other than a private foundation or a donor advised fund). Also, to be excludible, the distribution must otherwise be entirely deductible as a charitable contribution under Code Section 170 without regard to the charitable deduction percentage limits discussed above. Thus, if the deductible amount is reduced because of a benefit received in exchange, or if a deduction is not allowable because the donor did not obtain sufficient substantiation, the exclusion is not available for any part of the IRA distribution.

Illustration 1: Calvin, who is age 71, is the owner of a traditional IRA with a balance of $300,000, consisting solely of deductible contributions and earnings. He wants to make a contribution of $100,000 to his college before the end of 2006 to mark the 50th anniversary of his graduation. Calvin, who is a widower and files his tax return as a single taxpayer, expects to have AGI of $80,000 in 2006, itemized deductions of $15,700 (before taking the $100,000 contribution to his college into account) and a personal exemption of $3,300 in computing his taxable income. The itemized deductions of $15,700 include $10,000 of other contributions to public charities.

If Calvin takes a distribution of $100,000 from his IRA, his AGI for 2006 will be increased to $180,000. If he then contributes the $100,000 to his college, it will only increase his total charitable deduction by $80,000 ($90,000 [1/2 of AGI of $180,000] less the $10,000 of other charitable contributions he has made). While his gross itemized deductions will be $95,700 ($15,700 plus $80,000), the amount he may deduct will be reduced by $590 (.03 × [$180,000 of AGI − $150,500] = $885 × 2/3) to $95,110. In addition, his personal exemption will be reduced to $2,772 (.02 for each $2,500 (or fraction thereof) that his $180,000 AGI exceeds $150,500 = .24 × $3,300 personal exemption × 2/3 = $528; the $3,300 personal exemption − $528 = $2,772). Accordingly his taxable income will $82,118 (AGI of $180,000 less itemized deductions of $95,110, and less personal exemption of $2,772), and his income tax for 2006 will be $17,325 (rounded).

If instead, Calvin has the Trustee of his IRA transfer the $100,000 directly to his college, his AGI will not increase, and he will not be entitled to a charitable contribution deduction for the amount transferred from the IRA. His AGI will remain at $80,000, and there will be no reduction in his itemized deductions of $15,700, and his personal exemption of $3,300. His taxable income will be $61,000 ($80,000 less itemized deductions of $15,700, and less personal exemption of $3,300), and his income tax for 2006 will be $11,808 (rounded), or $5,517 less than it would have been if he had taken a distribution of $100,000 from his IRA and then contributed it to his college.

Observation: The $20,000 part of Calvin's contribution under the first alternative in illustration (1) that was not deductible in 2006 because his total charitable contributions were $20,000 more than 50% of his AGI could be carried forward to be used in 2007 to reduce his taxable income in that year. However, no part of his itemized deductions or personal exemption that was lost in 2006 because his AGI exceeded $150,500 could be carried forward.

If the IRA owner has any IRA with nondeductible contributions, the distribution is treated as consisting of income first, up to the aggregate amount that would be includible in gross income if the aggregate balance of all IRAs having the same owner were distributed during the same year. The annuity rules under which a pro rata part of the distribution would be treated as made out of nondeductible contributions don't apply. However, proper adjustments must be made in applying the annuity rules to other distributions made in the tax year and later tax years to reflect the amount treated as a qualified charitable distribution under this special rule.

Illustration 2: The facts are the same as in illustration (1) except that $60,000 of the $300,000 in Calvin's traditional IRA (20% of the total value of the IRA) consists of nondeductible contributions. If $100,000 is distributed to Calvin and then contributed to his college, only $80,000 will be included in his gross income (80% of the total distribution). On the other hand, if the $100,000 is transferred directly by the IRA's Trustee to Calvin's college, the entire $100,000 will be treated as coming from earnings and deductible contributions, no part will be included in Calvin's gross income, and $60,000 (30%) of the $200,000 amount remaining in the IRA will continue to consist of nondeductible contributions. Thus, if Calvin takes a further distribution of $10,000 from the IRA in 2006, only $7,000 (70% of $10,000) will be includible in his gross income.

Observation: Taxpayers who claim the standard deduction instead of itemized deductions in computing their income tax will also benefit from having charitable contributions made directly from their IRA to a public charity, instead of taking a distribution from their IRA and then contributing the amount of the distribution to the charity.

Even though a direct distribution from an IRA to a charity is not included in the taxpayer's gross income, it is taken into account in determining the owner's required minimum distribution (RMD) for the year. Thus, if the amount distributed directly from the IRA to an eligible charity at least equals the amount of the owner's RMD for the tax year, he will not be required to take any other distribution from the IRA for that tax year.

Illustration 3: Malcolm was 71 years old on June 1, 2006, and will file a joint tax return with his wife (also age 71) for that year. He will have to take an RMD from his traditional IRA of $3,000 before the end of 2006. He expects their AGI for 2006 to be $60,000 before taking the RMD into account. If he itemizes his deductions on his tax return for 2006, he will only be able to deduct $13,000 including a $3,000 contribution he plans to make to a local youth organization that is a public charity before the end of the year. If he takes a $3,000 distribution from his IRA, and then contributes $3,000 to the youth organization, his AGI will increase to $63,000 (for simplicity, we've not considered the effect of the increased distribution on the taxation of his Social Security payments). His taxable income will be $43,400 ($63,000 of AGI less itemized deductions of $13,000, and less two personal exemptions in the total amount of $6,600).

On the other hand, if Malcolm has the Trustee of his IRA transfer $3,000 directly to the youth organization, his AGI will be only $60,000. Even though the $3,000 won't be deductible on his tax return, his taxable income will be only $41,100 (AGI of $60,000 less standard deduction for 2006 of $10,300, less $2,000 additional standard deduction because Malcolm and his wife are 65 or older, and less two personal exemptions totaling $6,600). He will still be treated as taking his RMD of $3,000 for 2006, and will have taxable income that is $2,300 less than it would be if he had taken the IRA contribution himself and then donated $3,000 to the youth organization.

Recommendation: Taxpayers in Malcolm's situation who have already received their RMD for 2006, should consider holding off on the IRA distribution to charity until 2007.

 For more information on how this may affect your tax situation

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or email me at jacob@thefinancialfirm.com

 

Any discussion pertaining to taxes in our web site (www.thefinancialfirm.com) may be part of a promotion or marketing effort. As provided for in circular 230 of the IRS, advice related to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor.

Posted 12/14/06