The passage of the Tax Cuts and Jobs Act of 2017 has resulted in some major changes in the federal tax rules and cuts in individual marginal tax brackets starting in 2018. As a major consequence, most federal employees are noticing fewer federal income taxes withheld from their paychecks compared to the federal income taxes withheld during 2017 for the same amount of taxable wages. This column discusses qualified charitable distributions (QCD) which, also as a result of the new tax law, are now even more valuable to many current federal employees and annuitants and future annuitants with traditional Thrift Savings Plan (TSP) accounts and Individual Retirement Arrangements (IRAs).
A previous column discussed what a QCD is. To understand how QCDs allow for additional tax savings with the passage of the new tax law, it is important to review and discuss some of the major provisions of the new tax law.
The new tax law taking effect on Jan. 1, 2018, doubles the standard deduction to $12,000 for an individual filing single and $24,000 for a married couple filing jointly. This means that many federal employees and annuitants will be using the standard deduction rather than itemizing when they file their 2018 federal income tax returns in spring 2019.
A QCD allows an IRA owner age 70.5 and older to directly transfer a portion of his or her IRA to a charity. The amount transferred is excluded from income and most importantly, the transfer counts towards the required minimum distribution (RMD) of that IRA owner. The only downside is that the IRA owner does not receive a charitable donation. The annual limit for a QCD is $100,000 per person, which most probably will satisfy the RMD requirements for individuals over age 70.5. In the case of married couples in which both spouses are over age 70.5 and both have IRAs that require RMDs, each spouse can make QCDs of up to $100,000 each year.
Since many federal employees and annuitants age 70.5 and over may not have enough charitable, medical or other remaining deductions (starting in 2018, for itemizing purposes, state and local income taxes and real estate taxes will be limited to $10,000), they most likely will be using the standard deduction when they file their 2018 federal income taxes. Since the QCD from traditional IRA results in a reduction to income, the QCD is in effect adding to the standard deduction, thereby leading to less taxable income and overall tax savings. In short, excluding an amount from income (which the QCD does) results in a better tax benefit than receiving a tax deduction, such as a charitable contribution. This is because a QCD from a traditional IRA lowers gross income, resulting in lower adjusted gross income (AGI), more AGI-sensitive credits and deductions, and lower overall tax.
The following example illustrates:
Married couple with both spouses over age 70.5. In 2018, they do not have enough itemized deductions resulting in their claiming the standard deduction of $24,000 on their 2018 federal income tax return. The couple is in a 24 percent federal marginal tax bracket. Each spouse makes a QCD of $10,000 for a total of $20,000. In so doing, the couple effectively reduces their taxable income by $20,000, thus saving 24 percent of $20,000, or $4,800 in federal income taxes.
How TSP Participants Can Use QCDs to Eliminate TSP RMDs
As discussed above, a QCD can only be made from an IRA. federal annuitants age 70.5 and older must take a TSP RMD annually. This means that if a federal annuitant with a TSP account who wants to use a QCD to avoid the TSP RMD, then the annuitant would have to first transfer his or her TSP account to an IRA. Note that both the traditional (before-taxed) TSP and the Roth (after-taxed) TSP are each subject to the RMD rules once a TSP account owner/annuitant becomes age 70.5.
A TSP participant is permitted under current rules to directly transfer his or her traditional TSP to a traditional IRA and also can make a one-time transfer of his or her Roth TSP to a Roth IRA. The Roth IRA is not subject to RMD. In so doing, a TSP participant can take advantage of the QCD option for the traditional TSP. To take full advantage of the QCD option, a TSP participant is encouraged to perform these direct transfers before December 31st preceding the calendar year the annuitant becomes age 70. The reason is that the TSP RMD is calculated every year based in part on the participant’s TSP account balance on the preceding December 31st.
The following example illustrates:
Laura became age 70 on Jan. 13, 2018. Laura is a federal annuitant with a TSP account. Since Laura is retired from federal service and has reached her 70th birthday, she is required to start her TSP RMDs. Her first RMD is due no later than April 1, 2019 which is the April 1st after the year (2018) she becomes age 70.5 (July 13, 2018). Her first TSP RMD will be based on Laura’s TSP account balance as of Dec. 31, 2017.
If Laura were to directly transfer all of her TSP (traditional and Roth ) to a “rollover” IRA (traditional and Roth, respectively) sometime during 2018, then she would still have to make her TSP RMD for 2018 but no more TSP RMDs starting in year 2019. However, now that her traditional TSP has been transferred to a (rollover) traditional IRA, she will have to take RMDs for her traditional IRA starting in 2019. But Laura could make a QCD from her traditional IRA sometime during 2019 and every year thereafter in order to avoid traditional IRA RMDs.
The following is another example of where QCDs will save on federal and state taxes. Given the performance of the stock market over the last five to 10 years, it is not uncommon to find a TSP participant with a one million dollar TSP account balance. If the TSP participant is married to a federal employee with a TSP account, the combined TSP balance may be two million. TSP RMDs could be in the order of $40,000 to $50,000 per year per spouse, or a total of $80,000 to $100,000 for the couple per year. If the couple itemizes on their federal income taxes, then their charitable contributions are limited (under the new tax law taking effect Jan. 1, 2018 to 60 percent of their adjusted gross income (AGI). If their AGI is $150,000, then their charitable contribution is limited to $90,000 with the excess charitable contribution of $10,000 getting carried over to the following year. Furthermore, if the couple is in a 30 percent tax bracket, then the couple will pay $3,000 (30 percent of $10,000) in extra taxes this year. On the other hand, if the couple made a QCD of $100,000, their income would be fully reduced by the $100,000, thereby leading to full current year tax savings.
It is important for IRA owners age 70.5 and older to understand that a QCD can be performed each year (limit QCD of $100,000 per year per individual) and that the QCD fulfills the RMD requirement. But TSP participants need to perform some extra preliminary work; namely, transfer their entire TSP account to an IRA, ideally before the year they become age 70 – in order to annually take full advantage of the QCD and to avoid TSP RMDs.