Charitable Gifting Directly from an IRA

One of the seldom discussed “nuggets” in the recently enacted Pension Protection Act of ‘06 has tremendous benefits for those over 70.5 years old who have IRA balances and philanthropic inclinations. For tax year ‘06 and ‘07, these folks can contribute up to $100,000 to a qualified charity directly from their IRAs in each year. Although there is no tax deduction available for these donations, there is also no recognition of taxable income associated with the withdrawal.

Why is this so important? Traditionally, a client who so desired would have withdrawn funds from his or her IRA, reported that withdrawal as ordinary income and would be subject to tax at their regular income tax rate.

Upon donating those funds to a charity, they would be entitled to a tax deduction. The problem is that for higher income taxpayers their deductions were subject to “phase outs” and income limitation rules. The result would often find them not receiving a dollar for dollar deduction that would completely offset the IRA withdrawal. Thus, taking an IRA distribution and gifting that amount to a charity could actually end up costing the donor out of pocket. This limitation has been eliminated.

Perhaps equally, if not more important, people over age 70.5 years old face Required Minimum Distributions (RMD) each year. These often present a tax nuisance for higher income clients who live off cash flow from other sources.

The new law allows qualified charitable distributions from your IRA to apply against the RMD. Qualified donors not only get RMD credit for this and next year, but also effectively lower their adjusted gross income. This may help other areas of the tax return by lowering thresholds for medical expense deductions and for passive losses.

By reducing their IRA balance, clients can also lower their potential RMD in coming years and reduce their estate’s potential income tax burden for their heirs! The net result can be reduced taxes and greater flexibility for the future.

Consider the example of Janus Smith, a 71-year-old Montecito resident with a $1 million IRA. Assuming a 7% growth rate, her Required Distribution for 2006 will be about $37,735 and $40,323 in 2007. If she takes the minimum, her RMD in 2008 would be $43,085. Rather than meet her philanthropic interests from her savings, she elects to donate $100,000 this year and next directly from her IRA. By so doing, she not only preserves her after-tax savings but faces a reduced RMD in ’08 of $37,971 and proportionally less going forward.

A couple of procedural points to remember: Contributions must be made directly from the IRA custodian to a qualified charity. The IRA owner cannot take possession of the funds. Also, certain charities such as donor-advised funds and private foundations may not qualify. Finally, all charitable gifts must be documented and include an acknowledgment letter from the charity. Of course it is always a good idea to have your tax or financial advisor assist with coordinating these transactions.

Bear in mind that since this law is extremely new, many custodians and charities may not have their procedures fully in place. It is a good idea to begin early so to allow all parties extra time if needed.

Common financial wisdom suggests that an after-tax dollar may be more valuable than a pre-tax one within an IRA. When comparing the benefit of donating cash versus IRA funds to meet tithing obligations, pledges or just charitable inclinations, it is arguably more beneficial to draw down the IRA. Using this tax-advantaged technique helps preserve after-tax cash or savings as well as enhance tax flexibility for the future.