Understanding Qualified Charitable Distributions (QCDs): The Importance of Timing to Maximize Tax Benefits

A provision coming out of the Pension Protection Act of 2006 was the establishment of Qualified Charitable Distributions (QCDs). Effective January 1,2006 and ending December 31, 2007, QCDs were available to individuals aged 70.5 and older. Congress extended the December 31,2007 QCD deadline several times and made QCDs permanent as part the Consolidated Appropriations Act of 2016. SECURE Act 2.0 made two significant changes to the QCD rules.

This column discusses what a QCD is and how it can benefit individuals aged 70.5 and older. As will be explained, QCDs have a timing issue, and if this timing issue is not adhered to by a QCD participant, the tax benefits associated with a QCD will be lost.

SEE ALSO:

• TSP and IRA Tax-Planning Moves for Federal Employees and Retirees
• Answers to Tricky Tax Questions for the Thrift Savings Plan and IRAs

What is a QCD?

A QCD is a tax-free distribution from a traditional IRA made directly to a qualifying charitable organization. The QCD serves a charitable purpose on the part of the traditional IRA owner and can also serve to satisfy the traditional IRA owner’s annual required minimum distribution (RMD). Although not eligible for a charitable contribution tax deduction, a QCD is excluded from the traditional IRA owner’s adjusted gross income (AGI) under IRS rules. A reduction in the IRA owner’s AGI could potentially reduce those taxes that are based on AGI such as Social Security benefits and Medicare Part B monthly premiums.

QCDs are available to IRA owners aged 70.5 and older. During 2024, QCDs of up to $105,000 are allowed to be made.

Importance of Coordinating an RMD with a QCD to Maximize Tax Benefits

RMDs for traditional IRAs (but not Roth IRAs) start the year as a traditional IRA owner reaches his or her required beginning date, which over the last four years has increased from age 70.5 to age 73 (and eventually to age 75). For those traditional IRA owners with charitable intentions, a QCD can reduce and even eliminate the income tax due on RMD income.

However, timing is everything with respect to ensuring a QCD tax benefit. If not coordinated properly with a RMD, a QCD may be treated as ordinary income and therefore fully taxable. This is because the first dollars withdrawn from a traditional IRA in any year in which the traditional IRA owner is subject to RMDs are deemed to satisfy the RMD. This rule is referred to as the “first-dollars out” rule, that in turn creates a timing oddity for QCDs.

Timing Coordination When Executing a QCD

If a traditional IRA owner who is subject to RMD wants to offset the income from an RMD with a QCD, the two transactions must be performed in conjunction with each other. In particular, a traditional IRA owner cannot take their RMD and then retroactively perform a QCD with those same tax dollars. A QCD that is performed after an RMD is taken will result in an additional taxable distribution. If that happens, the RMD will be the first taxable distribution and the QCD will be the second taxable transaction within the same year. It is therefore highly recommended that a QCD should be done early in the year to avoid any conflict with the “first-dollars out” rule.

The following example illustrates how a QCD can become a taxable distribution:

Catherine, age 76, took her RMD of $12,500 from her traditional IRA in March 2023. In December 2023, Catherine withdrew another $12,500 from her traditional IRA thinking it will qualify as a QCD and offset the $12,500 RMD from her March 2023 traditional IRA distribution.

Catherine withdrew a total of $25,000 from her traditional IRA during 2023. All $25,000 will be included as taxable income during 2023 because Catherine took her RMD distribution of $12,500 in March 2023 before she took a QCD of $12,500 in December 2023. To avoid this outcome, Catherine should have performed her $12,500 QCD early in 2023 before she took her RMD. In so doing, no additional funds would have been needed to be withdrawn from her traditional IRA to satisfy her 2023 traditional IRA RMD. Furthermore, Catherine would have withdrawn only $12,500 as opposed to $25,000 and the distribution would have been completely tax-free because it is eligible for QCD treatment.

Which Retirement Accounts Permit QCDs?

Individuals aged 70.5 and older can perform QCDs. QCDs are permitted only from traditional IRAs, including inherited traditional IRAs. QCDs can be made from Roth IRAs only if the Roth IRA owner had not satisfied the requirements for a qualified Roth IRA distribution.

QCDs are not permitted from employer-sponsored retirement plans. This includes 401(k), 403(b), 457(b) retirement plans and the Thrift Savings Plan.

Some New QCD Rules Resulting from SECURE Act 2.0

SECURE Act 2.0, passed into law in December 2022, resulted in two new rules affecting QCDs:

• Maximum annual QCD amount is indexed to inflation. Beginning in 2024, the QCD maximum is linked to inflation. The 2024 QCD limit is $105,000 (had been $100,000 since 2006).

• One-time opportunity to fund a split-interest entity. Beginning in 2023, traditional IRA owners are offered a once-in-a-lifetime opportunity to use a QCD to fund a charitable remainder unitrust (CRUT), charitable remainder annuity trust (CRAT) or charitable gift annuity (CGA). The maximum (lifetime) distribution is $53,000 in 2024.
Interested individuals should talk to their financial advisor and/or tax professional whether this transaction can benefit them and the hurdles that must be satisfied in order to reap the tax benefits of this transaction.

Potential Tax Traps Associated with a QCD

There are seven potential QCD tax traps to be aware of. Each potential QCD tax trap is explained below.

• Direct transfer. To receive favorable tax treatment with a QCD, a distribution of traditional IRA must be done as a direct transfer to a qualifying charitable organization. Donor-advisor funds and private foundations do not qualify for QCD favorable tax treatment.

• Tax reporting of a QCD. A QCD is reported on IRS Form 1099-R (Distribution from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, etc.) as a normal IRA distribution and therefore included in taxable income. In other words, the 1099-R will not indicate that the distribution is a QCD and therefore a nontaxable transaction. It is up to the traditional IRA owner or beneficiary to advise their tax preparer to ensure that the favorable QCD tax benefit is received.

• Post-age 70.5 deductible traditional IRA contribution. SECURE Act 1.0 removed the age 70.5 limitation for contributing to a deductible traditional IRA. However, any individual over age 70.5 who makes a deductible traditional IRA contribution and subsequently performs a QCD will have the QCD – up to the amount of the deductible contribution to the traditional IRA – included as taxable income.

• Current year QCD only. A QCD can only be done for the current calendar year. For example, a QCD for 2024 must be completed by December 31, 2024. If the deadline is missed, the traditional IRA owner cannot make a QCD for a prior year.

• No charitable contribution deduction. A tax deduction cannot be taken on one’s federal income tax return as a result of performing a QCD. Also, nothing can be received by the traditional IRA owner from the charity in return for the charitable donation.

• Itemizing not required to perform a QCD. An individual age 70.5 or older is not required to itemize on his or her federal income tax return (file Schedule A) in order to perform a QCD.

• QCD must consist of before-taxed traditional IRA funds. There are traditional IRA owners over age 70.5 who own traditional IRAs that contain “basis” (after-taxed funds that were contributed to the traditional IRA). The question then comes as to how the traditional IRA then qualifies for QCD treatment. The answer is that QCDs are an exception to the IRS “pro-rata distribution” rule. QCDs are distributed from before-taxed funds first.