Taxpayers with traditional individual retirement accounts (IRAs) will be pleased to know that the IRA charitable rollover has finally been made permanent, allowing philanthropic individuals greater flexibility in their charitable giving and estate planning.
In many cases, taking a distribution from an IRA and then contributing it to charity generates a tax liability for the IRA owner. Even if the amount of the donation is the same as the amount of the IRA withdrawal, the charitable deduction might not fully offset the income generated by the withdrawal. For example, taxpayers who claim the standard deduction instead of itemizing their deductions would not get the tax benefit of their gift because the additional income resulting from the IRA withdrawal would not have a corresponding deduction. Higher-income taxpayers may also be subject to the Pease limitation on itemized deductions, which would reduce the value of the charitable deduction such that it would fail to completely offset the IRA distribution. In addition, if a taxpayer makes a cash donation to a public charity, he or she can only claim a deduction of up to 50% of his or her adjusted gross income (AGI). If the gift consists of appreciated marketable securities, the deduction is even more limited – to 30% of AGI. Any unused deduction can be carried forward for up to five years, at which point it would expire. In such cases, the taxpayer’s generosity would wind up generating a net tax liability.
To address these problems and encourage charitable giving more broadly, Congress enacted the IRA charitable rollover in 2006 as part of the Pension Protection Act. Consequently, an individual age 70.5 or older could donate up to $100,000 from his or her IRA directly to a public charity without having to treat the distribution as taxable income. Moreover, the donation to charity would count toward the taxpayer’s required minimum distribution (RMD) for the year.
Unfortunately, Congress got into the habit of only authorizing the IRA charitable rollover for one year at a time. Taxpayers often had to wait until December – or even later – to receive confirmation that the technique had been reauthorized for that year. By that point, however, most taxpayers would have already taken the RMD from their IRA for that year, making it impossible to use the IRA charitable rollover for those funds.
At year-end 2015, Congress finally enacted a law to make this technique permanent. As a result, taxpayers are now able to plan their charitable giving in a more reliable way. If a taxpayer is required to take a minimum distribution from an IRA that he or she does not otherwise need, that distribution can instead be directed to a public charity.
It is important to note that the IRA charitable rollover is not available to taxpayers who are younger than 70.5 years old, for amounts greater than $100,000 or for distributions to a private foundation, donor-advised fund or split-interest trust, such as a charitable remainder trust. Legislative attempts have been made over the years to broaden the technique to cover these additional situations, but most commentators believe that these efforts are unlikely to succeed, at least under the current administration.
To illustrate the benefits of the IRA charitable rollover, consider a 70-year-old taxpayer named Thomas, who has an investment portfolio that generates enough income for him to live comfortably, as well as a traditional IRA worth $1 million. Thomas is scheduled to begin taking annual RMDs from his IRA later this year, but he does not anticipate needing the extra income, which will be around $36,500 for the first year. He knows that leaving the IRA to his children will subject the IRA assets to both estate and income tax, resulting in well over half of the IRA being lost to taxes. Thus, Thomas is considering leaving his IRA to his alma mater to help satisfy a $2.4 million pledge that he made in honor of his late wife. The balance of his estate would then pass to his children.
Thomas’ wealth planner lays out two scenarios for him. Under scenario one, Thomas designates the university as the beneficiary of his IRA upon his death. He continues taking the RMDs, which will be taxable income to him. Assuming a 6% investment return, the total RMDs over the course of the next 20 years is projected to be $1,357,028. At a 38% marginal tax rate, this generates a cumulative tax liability of $515,671. The after-tax portion of each RMD is invested, and over the next 20 years, this “RMD pot” grows to around $1,443,975. If Thomas were to die at that point, the assets remaining in the IRA ($1,070,571) would pass to the university. The outstanding balance of his original pledge ($1,329,429) would have to be paid from his estate, essentially wiping out the RMD pot. The balance of the estate would pass to his children.
Under scenario two, Thomas directs his IRA custodian to begin distributing the amount of his RMD directly to the university every year. Over the next 20 years, $1,357,028 in RMDs is paid to the university, avoiding the $515,671 in income taxes that would have been due if Thomas had received the RMDs. These payments also reduce the amount of the pledge outstanding. At Thomas’ death, the $1,070,571 remaining in the IRA passes to the university as well, satisfying – and slightly exceeding – his obligation under the original pledge agreement. No additional payment is required from the estate.
Thomas prefers scenario two because it avoids the $515,671 in taxes that he would pay under scenario one, and instead applies this sum to the university’s benefit. The university also prefers scenario two because payments on the pledge would begin immediately, rather than upon Thomas’ death. This stream of RMDs could then grow to more than $2.2 million in the university’s tax-exempt hands, compared with a projected $1.4 million in Thomas’ after-tax hands. The difference is an additional $900,000 for the university at the end of the 20 years. Thomas’ children receive virtually the same amount under either scenario, so they do not object to scenario two. The parties also appreciate that the plan can be modified at any time, as Thomas can start keeping the RMDs for himself, rather than directing them to be paid to the university.
Now that the IRA charitable rollover has been permanently extended, taxpayers can more reliably incorporate this technique into their charitable gift planning. In some cases, this can lead to enhanced benefits for charity at little or no direct cost to the taxpayer’s family. To discuss this technique in greater detail, please contact your Brown Brothers Harriman wealth planner or relationship manager.
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.
This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products.
Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties.
All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH.
All trademarks and service marks included are the property of BBH or their respective owners.
© Brown Brothers Harriman & Co. 2019. All rights reserved.