National Association of Estate Planners and Councils

August, 2006 Newsletter
Provided by Leimberg Information Services

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Charitable IRA Rollover (CIR) in 2006 AND 2007

Professor Christopher R. Hoyt of the University of Missouri-Kansas City School of Law is currently the Chair of the American Bar Association's Committee on Lifetime and Testamentary Charitable Gift Planning (Section of Probate and Trust) and serves on the editorial board of Trusts and Estates magazine.

 

Chris is a frequent speaker at legal and educational programs and has been quoted in numerous publications, including The Wall Street Journal, Forbes, MONEY Magazine and The Washington Post.

 

Chris provides us with an in-depth look at the long-awaited (but alas only  lasting for two years) Charitable IRA Rollover (CIR).

 

EXECUTIVE SUMMARY:

The Pension Protection Act of 2006 provides that in 2006 and 2007, a person age 70 ½ or older can make charitable gifts directly from an Individual Retirement Account ("IRA") of up to $100,000 per year.  The donor will benefit by not having to report the IRA distribution as taxable income, although the donor will not be able to claim a charitable income tax deduction for the gift.

Eligible IRA owners can use charitable gifts from their IRAs to satisfy their annual minimum distribution requirement.  For example, a 76 year old who would normally be required to receive a taxable distribution of just over 4% from an IRA could instead contribute 3% to a charity and receive a taxable distribution of just 1%.

FACTS:

 The new law makes no change to the rules that govern charitable bequests of IRA assets, either outright to charities or to deferred giving arrangements.  Such transactions qualified for favorable income tax consequences in the past and will continue to be an attractive planning strategy in the future.  The new law only changes the rules for lifetime charitable gifts from IRAs.

NO COMPULSION:

The new law permits distributions to be made from IRAs directly to charities.

The new law does not compel IRA administrators to make such distributions when they receive instructions from the IRA account owner.  Thus, for example, whereas in theory every eligible person who claims the standard deduction will want to make each and every charitable gift directly from her or his IRA, the IRA administrators don't want to spend time cutting thousands or millions of checks for just $10 or $20.  They need to be able to administer these grants in a cost-efficient manner and develop a rational and reasonable fee structure. 

 

The charitable sector needs to be supportive of the needs and concerns of IRA administrators in order for the full potential of charitable IRA rollover to actually be realized.

 

COMMENT:

 

Who Wins With Charitable IRA Rollover?

 

1.  Donors who don't itemize their deductions

 

Probably the biggest winners of this new law are IRA owners age 70 ½ or older who do not itemize income tax deductions (i.e., they take the standard deduction).  Since the charitable deduction is an itemized deduction, they had the worst tax consequences from the gifts they made from their IRAs: they had to report the entire distribution as taxable income but received no offsetting income tax deduction.

 

Nearly two thirds of American taxpayers claim the standard deduction and the percentage is even higher for taxpayers over age 70 ½.   By comparison, the new charitable IRA rollover law gives eligible IRA donors the equivalent of an unlimited charitable income tax deduction for up to $100,000 of the charitable gifts that they make from their IRAs.[i]

 

Although non-itemizers are typically middle and lower income taxpayers, many are wealthy.  The IRS estimates that there are 5.7 million higher-income taxpayers who claim the standard deduction and cannot get any tax benefit from their charitable gifts.[ii]   They tend to live in the nine states that do not have a state income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming.  Donors (and, consequently, charities) who reside in these states will generally benefit more from the new charitable IRA rollover law than donors who live in other states.

 

 

2.     Donors Who Lose Tax Deductions As AGI (adjusted gross income) Increases.

 

The most common lost deduction is the phase-out of itemized deductions as income increases over $150,500 ($75,250 if married filing separately).  The phaseout was 3% in 2005 but is only 2% in 2006 and 2007.  By keeping AGI low, donors can deduct more of their itemized deductions.

 

Wealthy taxpayers cannot claim personal exemptions for themselves or their dependents.  Social security recipients may find that their social security benefits are subject to income tax but may avoid the tax by keeping their income under the thresholds.

 

Other deductions that are subject to income phase-outs, and the rates of phase-out, are:

 

          2% for "miscellaneous itemized deductions" (employee expense and investment expense deductions)
 


7 ½% for medical expense deductions 

10% for non-business casualty losses (e.g., damage to a vacation home)

      

3.      Donors who live in states with a state income tax that provides no tax breaks for charitable gifts.  

 

Indiana, Michigan, New Jersey, Ohio and Massachusetts state income tax computations do not permit itemized deductions.   Consequently,  Indiana, Michigan, New Jersey, Ohio and Massachusetts residents gets no state income tax breaks from charitable gifts.   

 

Eligible donors in these states will save taxes at their highest marginal state income tax rate (e.g., 4% or 6%) for every charitable gift that they make from their IRAs instead of from their checking accounts.   Although Illinois residents also cannot claim charitable income tax deductions, distributions from retirement plans are exempt from the income tax so they would not see any benefit on their state returns from this new law.

 

 

4.     Donors who are subject to the 50% charitable deduction limitation.

 

Charitable deductions cannot exceed 50% of a taxpayer's adjusted gross income ("AGI") in any year.[iii]  A donor who is subject to the annual deduction limitation and who uses a taxable distribution from a retirement plan account to make an additional charitable gift would generally be able to deduct only 50% of the amount in the year of the gift.  The other 50% of the distribution would be subject to income tax that year.

 

If, instead, the charitable gift is made directly from an IRA, a donor over age 70 ½ would not pay any extra income tax.

 

 

LEGAL REQUIREMENTS

 

A.    Overview

 

A person age 70 ½ or older who makes an outright charitable gift from her or his IRA:

 

(1) will not have to report the distribution as taxable income,[iv] and

 

(2) will not be entitled to claim a charitable income tax deduction for the gift.[v]

 

B.    Technical Requirements for Outright Gifts

 

In order to make a lifetime charitable gift from an IRA without having to report the payment as a taxable distribution, the distribution must meet the definition of a "qualified charitable distribution" (hereafter "QCD").[vi] 

 

Unless a distribution qualifies as a QCD, any lifetime charitable gift from any sort of retirement plan account (IRA, 403(b), 401(k), profit sharing, etc.) must be reported as a taxable distribution.  The donor can then claim an offsetting charitable income tax deduction.

 

There are six requirements for an IRA distribution to qualify as a QCD:

               

 

1.   Donor must be at least age 70/12. 

 

The distribution must be made on or after the date that the IRA owner attained age 70 ½..[vii]  In most cases such donors will be retirees.

 

Donors under age 70 ½ will have to report charitable gifts from their IRAs as taxable distributions and can claim offsetting charitable income tax deductions if they itemize their deductions.

 

TAX TRAP:

 

There can be a lot of confusion in the year that a person attains age 70 ½.

 

It is true that all distributions that are made at any time during that year can be applied toward satisfying the minimum distribution requirement to avoid the 50% penalty tax.

 

But ONLY the distributions that are made on or after attaining the age of 70 ½ qualify for the charitable exclusion! (Play it safe and tell clients not to have any distributions made to charity until at least one or two days after they reach age 70 ½).

 

This can be a problem for someone who attains age 70 ½ late in the year, say on December 28.

 

The law should be changed in a technical corrections act to conform the charitable IRA rollover rules with the minimum distribution requirements.  That is, all distributions should qualify if made "within or after the calendar year that the individual for whose benefit the plan is maintained has attained age 70 ½".  Tax administration would be simplified and innocent parties would not be caught in a tax trap.

 

2.   TAX TRAP:  IRAs only.

 

The distribution must be made from an individual retirement plan.[viii]  That means ONLY an IRA --NOT a qualified retirement plan or a Section 403(b) annuity.   Distributions to charities from other types of retirement accounts -- such as 403(b) plans, 401(k) plans, profit sharing plans and pension plans -- will still have to be reported as taxable distributions to the account owners.

 

TAX TRAP:

 

Another trap that may lead to confusion is that charitable gifts from SEPs and SIMPLE plans, which are basically IRAs that receive employer contributions, are ineligible for the exclusion.

 

In most cases, the restriction of such favorable tax treatment to IRAs should not pose a significant problem.  Many retirees have large IRA balances because they rolled over distributions from their company retirement accounts into IRAs when they retired.

 

PLANNING TIP:

 

Donors without IRAs who would like to take advantage of charitable IRA rollover can establish a new IRA and then rollover some assets from their other qualified retirement plans into the new IRA.[ix]

 

3.   TAX TRAP:  Directly from the IRA to the charity rule.[x] 

 

If a check is paid from the IRA to the IRA owner who then endorses the check to the charity, it must be reported as a taxable distribution to the IRA owner.  To comply with the CIR law, the money must go directly from the IRA to the charity.

 

4.     The recipient organization must be a public charity or a conduit private foundation.

 

The recipient organization must be described in Sec. 170(b)(1)(A).[xi]

 

TAX TRAP:  Donor advised funds and supporting organizations:

 

Contributions to donor advised funds and Sec. 509(a)(3) supporting organizations qualify for public charity tax deductions.

 

But they are not eligible beneficiaries for charitable IRA rollover.

 

In that case, the donor must report the IRA distribution as taxable income and then claim an offsetting charitable income tax deduction.

 

5.     The payment would otherwise fully qualify for a charitable income tax deduction.[xii]

 

A distribution will qualify as a QCD only if a person would normally be able to claim a charitable income tax deduction for the entire payment.  This eliminates favorable tax treatment for IRA distributions that are used for auctions, raffle tickets, fund-raising dinners or any other type of quid-pro-quo transaction. 

 

If there is any financial benefit, then the entire distribution is taxable income and the donor must hope to get a partially offsetting charitable income tax deduction.

 

6.     Distribution would otherwise be a taxable distribution.[xiii]

 

By way of background, most IRA distributions are fully taxable.  However, if an IRA owner made any nondeductible contributions to the IRA, then those distributions to the IRA owner are normally tax-free.  A QCD only applies to the taxable portion.

 

The new law provides very favorable tax treatment for outright charitable gifts from IRAs that hold non-deductible contributions.  Charitable distributions are deemed to come first from the taxable portion, thereby leaving the maximum amount of tax-free dollars in the IRA.[xiv]  An example is in the footnote[xv]  from Example 2 of "Technical Explanation Of H.R. 4, The Pension Protection Act of 2006", Prepared by the Staff of the Joint Committee On Taxation August 3, 2006 (JCX‑38‑06) on page 268.

 

If any tax-free amounts are distributed to a charity, that portion does not qualify as a QCD.  Instead, the donor is deemed to have received that amount free from income tax and can claim a charitable income tax deduction for a charitable gift of that part of the payment.

 

CONCLUSION

 

There will be administrative obstacles in the short term as IRA administrators learn to adapt to this new law.  IRA administrators will be reluctant to invest a lot of effort to modify computer systems for a law that will expire at the end of 2007.

 

An eligible IRA owner over the age of 70- ½ should, therefore only attempt to make a charitable IRA rollover if the tax savings exceed the administrative costs that the transaction might generate.  For people who itemize their deductions and can claim offsetting charitable income tax deduction, it will usually be administratively easier to simply receive a check from the IRA and then make a charitable gift.

 

However, for those individuals who do not itemize, who live in states with no charitable deduction or who otherwise benefit by keeping their AGI lower, it may be worth the effort to work with the IRA administrator to make that large charitable gift from the IRA.

 

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

 

Chris Hoyt

 

Edited by Steve Leimberg

 

CITE AS:

 

Steve Leimberg's Charitable Planning Newsletter #101  (August 7, 2006) at  http//www.leimbergservices.com

 

Reproduction in Any Form or Forwarding to Any Person Prohibited - Without Express Permission.

 

(c) 2006 Christopher R. Hoyt  All Rights Reserved

 

CITES:

 

For a summary of the Charitable Provisions of the Pension Protection Act of 2006 (to be signed into law Thursday, August 17, 2006):

 

http://waysandmeans.house.gov/media/pdf/taxdocs/072806charitable.pdf

 

Click here for the ActualText of H.R. 4 - The Pension Protection Act of 2006.

FOOTNOTES


 


[i]           The ability to avoid reporting taxable income from IRA distributions in the first place produces a similar result to (a) reporting an IRA distribution as taxable income and then (b) claiming an offsetting charitable income tax deduction for the entire amount.

[ii]           Balkovic, Brian, "Individual Income Tax Returns, Preliminary Data, 2001, SOI Bulletin, Data Release, Winter 2002-2003, p. 136.

[iii]          Secs. 170(b)(1)(A) and (C) and Reg. Sec. 1.170A-9(e)(11)(ii).  There is a 5 year carry-forward for the charitable contributions that exceed 50% of AGI.  Sec. 170(b)(1)(C)(ii) and last sentence of Section 170(b)(1)(B).

[iv]          Sec. 408(d)(8)(A).

[v]           Sec. 408(d)(8)(E).

[vi]          Sec. 408(d)(8)(B).

[vii]         Sec. 408(d)(8)(B)(ii).

[viii]         Sec. 408(d)(8)(B).

[ix]          Sec. 408(d)(3).  Employees who receive distributions from any type of qualified retirement account can rollover the distribution to an IRA.

[x]           Sec. 408(d)(8)(B)(ii).

[xi]          Sec. 408(d)(8)(B)(i).

[xii]         Sec. 408(d)(8)(C).

[xiii]         Sec. 408(d)(8)(B) (last sentence).

[xiv]         Sec. 408(d)(8)(D).

[xv]          Example: An IRA owner has a traditional IRA with a balance of $100,000, consisting of $20,000 of nondeductible contributions and $80,000 of deductible contributions and accumulated earnings.  Normally, 80% of a distribution to the IRA owner would be taxable and 20% would be a tax-free return of non-deductible contributions.  If however, there is a distribution to a charity that qualifies as a QCD, all of the distribution is deemed to come first from the taxable portion.  Thus, if the IRA trustee makes an $80,000 distribution to a charity, the entire $80,000 is deemed to come from the taxable portion of the IRA and is a QCD.  No amount is included in the IRA owner's taxable income.  The $20,000 that remains in the IRA is treated as entirely nondeductible contributions.

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