For federal annuitants and employees, the year 2020 has been a somewhat confusing and challenging year when it comes to charitable giving. The SECURE Act, passed into law on Dec. 19, 2019, and the CARES Act, passed into law on March 27, 2020, are mostly responsible for the confusion.
This column discusses the confusion and what federal annuitants and employees — particularly those over 70.5 — should do when it comes to charitable giving with a goal of saving on federal and state taxes for themselves and their families.
Among the provisions of the SECURE Act is that the starting age for required minimum distributions (RMDs) for traditional IRA and defined contribution plans (including the Thrift Savings Plan (TSP)) is raised from 70.5 to age 72. The “required beginning date” for RMDs is now April 1 following the year an individual becomes age 72 and applies to individuals born after June 30, 1949. However, the SECURE Act did not change the minimum age – age 70.5- that allows traditional IRA owners to directly contribute their traditional IRA assets to qualified charities. In so doing, the direct traditional IRA contribution is used to either partially or to entirely fulfill the traditional IRA owner’s RMD requirement for the year. This direct contribution of the traditional IRA assets to a qualified charity is called a qualified charitable distribution (QCD) and was made available permanently by Congress about four years ago.
In late March 2020, Congress passed the CARES Act which, among its provisions, suspended all RMD payouts for 2020, a result of the coronavirus pandemic and subsequent stock market downturn. The suspension gives individuals’ retirement “nest eggs” (like the Thrift Savings Plan) a chance to recover from the stock market losses that were particularly ugly in March 2020.
The two changes – in particular the 2020 RMD suspension – will likely affect charitable giving strategies among federal annuitants over age 70.5 who used QCDs in order to save on federal and state income taxes and to give to their favorite charities.
Before explaining what federal annuitants over age 70.5 who have traditional IRA assets should do this year and in 2021 in order to minimize their overall tax liabilities through charitable giving, it is important to review QCDs and how they can benefit federal annuitants over age 70.5 who own sizeable traditional IRAs, perhaps a result of directly transferring or rolling over their traditional TSP accounts.
Traditional IRA owners over the age of 70.5 can donate up to $100,000 each year of IRA assets directly to qualified charitable organizations. Note that IRAs invested in donor-advised funds are not eligible for QCDs. QCDs up to the annual $100,000 limit in any year are counted towards the traditional IRA owner’s annual RMD.
While there is no charitable contribution deduction associated with a QCD, the traditional IRA distribution associated with the QCD is not included in the IRA owner’s annual adjusted gross income (AGI). Normally, at least a portion of a traditional IRA distribution is included in one’s gross income. But the advantage is that by not including the traditional IRA distribution in one’s income, the IRA owner is not increasing his or her AGI and at the same time, partially or entirely fulfilling his or her annual traditional IRA RMD requirement.
Not increasing one’s AGI can result in possibly avoiding “stealth” taxes that are based on AGI. These “stealth” taxes include income-based Medicare Part B and Part D premiums, and a 3.8 percent Medicare surtax. The 3.8 percent surtax applies to net investment income such as dividends or capital gains. The threshold for the Medicare surtax is AGI of $250,000 for married individuals filing jointly and $200,000 for most single filers.
Note again that QCDs, while not included as an itemized deduction as part of an individual’s IRS Form 1040 Schedule A “charitable contributions”, are also not included as income in the individual’s AGI. Since most annuitants take the standard deduction and do not itemize on their federal income taxes, there is in reality no loss of a deduction because charitable contributions are part of Schedule A (itemized deductions). In short, for individuals who use QCDs, there are “indirect” tax savings through a lower AGI and taxable income.
But the year 2020 is a different year when it comes to using QCDs. Under the CARES Act, RMDs are suspended. Consequently, any QCDs taken during 2020 will not reduce RMDs and therefore will not result in any reduction of one’s AGI. This means that many traditional IRA owners who in past years were required to take their RMDS (but in 2020 will not) can reap a bigger tax break by not taking any QCDs in 2020 and instead, doubling up their QCDs in 2021 when RMDs will have to be taken.
The following example illustrates:
Jonas, age 72, a federal annuitant, has a traditional IRA that he transferred over from his traditional TSP. As of Dec. 31, 2018, his IRA was worth $1,560,000. During 2019 when Jonas was 71, his RMD was computed to be:
$1,560,000 (value on 12/31/2018)/26.5 = $58,868.
Jonas made a QCD in 2019 of $29,000, thereby reducing his 2019 AGI by $29,000 so that the amount of his RMD included in his AGI was $29,868. On 12/31/2019, Jonas’ IRA was worth $1,600,000. Had he been required to take an RMD for 2020, his 2020 RMD would have been equal to:
$1,600,000/25.6 = $62,500.
Jonas does not have to withdraw the $62,500 in 2020 due to the suspension of the RMD for 2020.
But in 2021, when Jonas will presumably have to resume taking his traditional IRA RMD, he intends to double his QCD to $58,000. If his RMD for 2021 turns out to be about $65,000, he will only have to report $7,000 of income in 2021.
It should be further noted that under the CARES Act, all individuals can donate to qualified charities up to $300 during 2020 as an “above the line” deduction. In other words, individuals do not have to itemize in order to reap the tax benefit from donating to a qualified charity during 2020.
Finally, there are suggestions for federal employees and annuitants younger than age 70.5 who wish to maximize their charitable gifting and reduce their overall tax liabilities. If they own traditional IRAs and they do not want to wait until they are age 70.5 in order to use QCDs, they can donate their traditional IRA assets now directly to a charity and, assuming they itemize on their federal income tax returns (file Schedule A) get a current year tax deduction, usually up to the fair market value of the asset.
Appropriate IRA assets for charitable giving include highly appreciated capital assets – stocks, bonds, mutual funds, exchange-traded funds, etc. – that can be donated to a qualified charity. The reason for donating highly appreciated IRA assets (rather than cash or capital assets held outside of a retirement account) is that it allows the donor to avoid paying the capital gains tax on the accumulated asset growth (had the asset been sold) and to take a full charitable deduction (with some AGI limitations) on the capital asset’s full market value on the day of donation. This strategy of donating highly appreciated IRA assets is a favorite strategy among wealthy donors over age 70.5 who want to donate more than the $100,000 annual limit for QCDs.
Another reason for considering the donation of IRA assets to qualified charities is for income tax savings. Holding onto highly appreciated capital assets invested in non-retirement accounts until death can result in income tax savings for the heirs who are bequeathed these assets. The owner of capital assets who bequests these assets to heirs (through a will or a trust) will likely pay no estate taxes upon their death at which time these assets are transferred to their heirs.
Because these assets are inherited by the named heirs, the heirs receive what is called a “step-up” in cost basis of these assets. The cost basis to heirs is equal to the fair market value of the capital asset on the day of the owner’s death. This means the heirs will pay little if any capital gains tax should they immediately sell their inherited capital assets.
In short, for tax purposes the heirs will thank relatives who bequeathed their capital assets held in taxable (non-retirement) accounts to the heirs while donating their traditional IRA assets to charities and receiving the immediate tax benefits. This is because had instead the heirs inherited the traditional IRA assets as beneficiaries, then full ordinary income taxes would have to be paid by the beneficiaries when the traditional IRA assets are withdrawn.
Under the SECURE Act, effective Jan. 1, 2020, any inherited traditional IRAs must be withdrawn no later than ten years following the death of the traditional IRA owner, with the designated beneficiary(s) (with some exceptions) paying the full federal and state income taxes due. There is no “step-up” in cost basis nor any preferential federal capital gains tax treatment on traditional IRA asset withdrawals.