If you’re required to take Required Minimum Distributions (RMDs), then knowing your options is important. Qualified Charitable Distributions (QCDs) are a useful tool to keep in mind.
You need to know the benefits and drawbacks of QCDs if you’re already taking RMDs or anticipating doing so. Let’s discuss what QCDs are and whether they should be in your arsenal of tax fighting weaponry.
First, let’s talk about what RMDs are. Required Minimum Distributions (RMDs) are the minimum amount of money that you must withdraw from your retirement accounts each year. Otherwise, you’ll incur a penalty for not making the RMD.
This distribution is taxed as ordinary income just like any other distribution. This may not be an issue for you. However, the penalty for not withdrawing the proper amount is 50% of the money you failed to take out as a distribution. Yikes!
You want to be sure you’re taking out the proper amount.
In general, all retirement accounts except Roth IRAs are subject to RMDs. This includes all “employer sponsored” plans like the 401(k) (including Roth 401(k) accounts), 403(b), 457(b), IRAs (including SEP, SIMPLE, and SARSEPs), and profit-sharing plans.
For the year in which you turn 72, you actually have until April 1st of the following year to take your first RMD. However, if you do choose to delay your first RMD to 4/1 of the next year, you will have to take your next RMD by 12/31 of that same year. After that, and each subsequent year, 12/31 is the RMD deadline.
You might be wondering, “What’s the big deal?” You saved this money to spend in retirement, so why not use it? There are some potential issues.
For starters, you might just not need the money right now. You may be trying to employ tax saving strategies in retirement. If the markets are down, you might not want to withdraw much money, if any, from your portfolio. Also, you may have other income and the RMDs would push you into a higher tax bracket.
All of these make RMDs a potential headache (and tax burden). So how do you avoid RMDs altogether?
There are very few ways to avoid RMDs entirely. The most obvious that come to mind are not saving any money for retirement (just kidding, NOT recommended!) or getting your retirement savings into a Roth IRA. The latter is the obvious choice here.
It’s important to note that we’re talking about a Roth IRA, NOT a Roth 401(k). A Roth 401(k) has higher contribution limits than a Roth IRA BUT is subject to RMDs.
The most common way to get traditional retirement accounts into a Roth IRA is by doing Roth Conversions. This involves transferring money from your retirement account (IRA, 401(k) accounts), 403(b), 457(b), etc) into a Roth IRA. You pay taxes in the year of the transfer. Then the money in the Roth IRA will continue to grow tax free and avoid RMDs.
There is one exception to the rule for Roth IRAs to be exempt from RMDs (isn’t there always one?). An inherited Roth IRA is subject to RMDs. The beneficiary does have some additional options for distributions though.
Regardless, distributions must start no later than December 31st the year after the original account holder passed away or would have reached age 72.
Let’s say that you can’t avoid RMDs altogether for one reason or another. Now what?
You will have to take distributions from the account no matter what. However, there is a way to withdraw money from the account without paying taxes – enter the Qualified Charitable Distribution (QCD).
The Qualified Charitable Distribution (QCD) is pretty much exactly what it sounds like. It’s a charitable contribution that also qualifies toward your Required Minimum Distributions for the year. QCDs are made directly to your charity of choice.
There are several rules surrounding QCDs, but they can be a helpful tool if:
The basic criteria to be considered a QCD are that you make the distribution from your retirement account directly to a qualified charity and are over the age of 72. The maximum you can contribute is $100,000 as a QCD each year ($200,000 if married filing jointly).
The key thing is that the money goes directly to the charity. You can’t take the distribution and then donate it to charity.
The main benefits of the QCD are:
Since the money is sent directly to the charity, it is not taxed. Normally, if you take a distribution and donate it to the charity, then your original distribution is subject to your normal income tax rate. If a qualified charity receives the money via QCD, you are not taxed, and it doesn’t raise your Adjusted Gross Income (AGI) either.
The fact that a QCD doesn’t raise your AGI is an important distinction. Your AGI is used to determine many different tax rates as well as your Medicare Part B premiums. If you’re already at the limits for these, then a QCD may be beneficial.
Even though you didn’t receive the money directly, the distribution still counts toward your required distribution amount. This meets the IRS requirements in part or in full. You don’t have to use the QCD to satisfy the RMD requirement in full.
Example: If your RMD was calculated at $20,000 for the year and you made a QCD of $10,000, you can make a normal distribution for the remaining RMD of $10,000.
This might be the most obvious benefit of the QCD. If you can help one of your favorite charities and avoid paying taxes, it really is a win-win!
There are some notable limitations for QCDs. These are:
Although this doesn’t seem like a huge problem, it can be limiting in some instances. Keep in mind that spouses can combine their QCD limit if they file jointly.
The specification that the QCD must go to a qualified charity directly can be restrictive. You cannot contribute to a Donor Advised Fund (DAF) to qualify as a QCD.
Overall, there could be more tax-efficient strategies like donating appreciated securities from a taxable account. This is going to depend on your situation. If you don’t have appreciated securities to donate, this is a moot point.
Without knowing your situation, it’s hard to tell. There are a multitude of options for how to give to charity. The QCD is more helpful in situations where you don’t want to incur RMDs and don’t want to raise your taxable income.
You should pay particular attention to QCDs if you are close to the income limits for capital gains tax, income tax, or Medicare Part B premium rates. Your AGI is also important to look at if you are likely to be subject to the Net Investment Income Tax (NIIT) of 3.8% (for 2022).
A QCD is useful if your RMDs will raise your Adjusted Gross Income (AGI) above these thresholds, you don’t need the money, and you don’t have other preferred options available. If giving to charity is a goal, you should be aware of how each method of giving affects your entire financial picture.
Overall, the Qualified Charitable Distribution is a useful tool. You may never want or need to use this strategy, but you never know. The primary line of defense against RMDs is going to be dialing in your income and utilizing Roth conversions.
However, everyone’s situation is different. If you’re up against a 50% penalty, having additional options like the QCD is super helpful!
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