Some tax strategies are so common most people know about them. Why is it then almost nobody is using the strategy?
A large part of my tax practice is consulting. There isn’t much room for more tax preparation clients. However, I love helping people reduce their taxes, so I spend considerable time outside tax season working with good people designing strategies tailored to their personal needs.
The past several months I have repeated the tax break in question countless times. It is missed nearly 100% of the time. Of my regular tax clients, the ones using this strategy did so at my encouragement.
It started earlier this year when I published this post on traditional retirement accounts and how they have an implied interest rate on the tax savings. Before that I published this post because I was seeing consulting clients who had rather large retirement accounts at a young age.
It is to be expected in a community of savers and investors to have large retirement accounts at an early age. My lament was about how big those accounts were going to get and the loss of control over tax issues in the future as a result.
When the accountant loses control over managing your taxes it means you pay more. This might not seem like a such a big deal because these people have a large amount of liquid investments, much of it in traditional retirement accounts, and can afford to pay more in taxes. But people don’t stop by this place to hear they need to pay more.
Folks around the FI (financial independence) and FIRE (financial independence/retire early) communities tend to max out tax deductions up front so they can build their net worth faster. I cautioned against this knee-jerk reaction.
Most people in these communities would be hard pressed to give the appropriate amount to invest in a Roth versus a traditional retirement account for their optimum tax advantage over their lifetime. At Camp Accountant I discussed the issue further.
The more I thought about the issue of large traditional retirement account balances the more I realized this was not just a wealthy person issue. There is a tax strategy with the ability to make a real difference for people even in lower tax brackets, in fact, any tax bracket.
The problem is the required minimum distribution (RMD). Before the RMD kicks in at 70 1/2 you retain control over your tax situation by making choices best for you. In the earlier posts I outlined how some people with modest traditional retirement account balances would see very large balances after another 30 years of growth. I illustrated an example of a client facing $500,000 in RMDs down the road. There isn’t much tax planning you can do after that.
Of course, many readers felt this was not a real world issue. It is, but not for many.
The problem with the RMD is loss of control. Once you reach 70 1/2 you have until April 1st of the following year to distribute a certain amount from your traditional retirement accounts. If you wait until the following year you need to take out double that year. Therefore, for most, it is best to start taking the RMD the year you reach 70 1/2.
The RMD is required every year you have a traditional retirement account once you reach 70 1/2. The Secure Act working its way through Congress could delay the RMD until age 72, but that has not yet happened. If you are still working you can delay the RMD for money in the 401(k) where you work, with some restrictions.
The RMD can do serious tax damage. For example, if your only income is Social Security and an RMD from your retirement account of $40,000, some of your Social Security benefits will be taxed. Worse, you could pay more for Medicare coverage the following year.
By age 70 you are probably not itemizing. The house is paid off so all that remains is state and local taxes (SALT), which are capped at $10,000 per return, and charitable contributions. Yes, if you have really high out of pocket health insurance and medical expenses you might get a deduction there, but it is really hard to get the deduction as the first 10% of adjusted gross income (AGI) needs to be exceeded before you can claim any of the healthcare expense.
If you donate large amounts to charity there is another problem. The RMD increases your taxes and could turn some of your Social Security benefits taxable as well. Then you need to exceed the standard deduction ($24,400 for joint returns/$12,200 for singles for 2019) before any of the charitable deduction counts.
And that is where out tax strategy shows up.
The Gift that Keeps on Giving
Under current tax law you can give to charity directly from your traditional retirement account (tIRA, SEP and SIMPLE, including inactive SEP and SIMPLE plans that no longer receive contributions), up to $100,000 per year, per person, once you reach age 70 1/2. If you are not this old yet you certainly have friends, family and neighbors who are and they need to hear about this.
Money sent directly to a charity from your traditional retirement account is excluded from income up to the $100,000 limit!
For this to work the retirement plan administrator must send the money directly to the charity. You will still get a 1099-R at the end of the year. Nothing on the tax document tells you how much was sent directly to the charity so you must tell your tax professional the amount to get the tax break. My office tax software has a “special situations” page I go to on the 1099-R screen to enter the amount to exclude from income.
This is important. While only a few will suffer the consequences I outlined in prior posts, many will pay at least some tax on their RMD. Many will also end up paying tax on up to 85% of their Social Security benefits and pay more in Medicare premiums than they have to.
Let me clear up a few points before continuing. You can have more than the RMD sent to the charity from your retirement account. The limit is $100,000 per person, per year, as stated above, that can be excluded from income each year, even if your RMD is lower. If you give more than the RMD, the excess will not lower the next year RMD, but is still excluded from income up to to the limit. The RMD is still required in subsequent years without regard to prior distributions in excess of the RMD in past years.
There are no drawbacks from using this tax strategy. The qualified charitable distribution (QCD), as this strategy is called, is excluded from income, never reaching the front page of Form 1040. This means that your income is lower. Your Medicare premium may be lower as a result and Social Security benefits might be taxed less or not at all.
There are other issues on your tax return that might be affected as well. Your facts and circumstances will determine those additional tax savings.
There is one lifestyle change required if you are donating to your church, synagogue or other religious organization. You should make your donation via your traditional retirement account, up to $100,000, to your church. No more money in the plate on Sunday (or whichever day you have services). This means you will not be tossing an envelope in the plate at the service. It’s no big deal because the additional tax savings mean you can fund your religious organization more from the tax savings. But it might feel weird not donating to church each week when the plate is passed.
You must be 70 1/2 or older at the time of the donation, not just the year you reach 70 1/2. If you reach 70 1/2 on November 18th, then the first day you can gift with a QCD is November 18th.
Be sure the charity gives you a receipt for the donation. You will need it for your tax records should you be audited.
Who Can You Donate To?
This is where it gets fun. The Internal Revenue Code (IRC) allows a wide range of organizations you can donate to under a QCD, as listed under IRC Section 170(c). Here is the list in English:
- A U.S. state, possession, the District of Columbia and the United States federal government itself. Yes, the government will give you a tax break for giving all the money to them. Just had to get that out of the way.
- Any community chest, corporation, trust, fund or foundation (organized or created in the U.S.), operating exclusively for charitable, religious, educational, scientific, or literary purposes, or for the prevention of cruelty to children or animals.
- Your church, synagogue or other religious organization.
- War veterans’ organization or its post, auxiliary, trust, or foundation organized in the United States or its possessions.
- Nonprofit volunteer fire companies.
- Certain civil defense organizations.
- Domestic fraternal societies (operating under the lodge system), if the contribution is used exclusively for charitable purposes.
- A nonprofit cemetery company in some instances.
Part of your legacy planning starts long before your leave this world. You can make a difference. You built wealth with hard work, frugal living and prudent investing. These skills mean you are unlikely to spend it all. By giving to worthy charities of your choice you can enjoy the fruits of your giving by seeing your donations in action.
By using the QCD tax strategy you can reduce your taxes, reduce or avoid taxes on Social Security benefits and potentially reduce your Medicare premiums. This means you will have a larger legacy for your loved ones or to fund charitable causes dear to your heart at a greater level.
You worked hard for your money. Now you can make a bigger difference than ever. The pay-it-forward revolution starts here.
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