If an individual taxpayer receives a distribution from an IRA, and then contributes all or part of the amount distributed to a charity, that individual must include the taxable part of that distribution in her gross income.While the distributee is entitled to a charitable deduction for the amount contributed, this will reduce taxable income only if she itemizes deductions, instead of claiming the standard deduction. Even if an individual itemizes, the amount deductible may be less than the amount contributed because:
* The total amount contributed to charity is limited to a specified percentage of the individual's adjusted gross income computed without regard to any net operating loss carryback, e.g. 50 percent in the case of contributions to public charities, certain governmental units, and private foundations other than private non-operating foundations.
* The distribution from the IRA will increase AGI even if the entire amount is contributed to charity, and this could cause a reduction of other tax benefits when AGI exceeds certain specified levels, e.g., a reduction in the allowable amount of itemized deductions, personal exemptions, and/or education credits that the taxpayer would otherwise be allowed to take.
Example 1: Your client, who is 72 and a widower, files his income tax return as a single taxpayer. At the end of 2005, he had a balance of $500,000 in his traditional IRA, consisting entirely of deductible contributions and earnings. He plans to make a contribution of $100,000 to his college before the end of 2006 in honor of the 50th anniversary of his graduation. He will take a distribution of $100,000 from his IRA to make the contribution. Since no part of the distribution from his IRA will consist of nondeductible contributions, the entire amount distributed will be includible in his gross income.
Before taking the distribution from his IRA into account, your client expects his taxable income for 2006 to be $75,000, i.e., AGI of $100,000, less itemized deductions of $21,700 (including $15,000 of other contributions to public charities), and less a personal exemption of $3,300.
After your client takes a distribution of $100,000 from his IRA and then contributes that amount to his college, your client's AGI for 2006 will increase to $200,000. However, even though the entire $100,000 is contributed to his college, his itemized deductions (before taking any phase-out into account) will only increase by $85,000 to $106,700, since his total charitable contributions of $115,000 will be $15,000 more than $100,000 (50 percent of AGI of $200,000).
In addition, the amount of allowable itemized deductions will be reduced by $990 (two thirds of 3 percent of $49,500 (the excess of AGI of $200,000 over $150,500, the amount at which itemized deductions start to be reduced)) to $105,710, and his personal exemption will be reduced by $1,320 (40 percent of $3,300 (2 percent for each $2,500 (and fraction of $2,500) by which AGI of $200,000 exceeds $150,500, the amount at which personal exemptions start to be reduced for a single taxpayer)) to $1,980.
Your client's taxable income for 2006 will be $92,310 (AGI of $200,000, less itemized deductions of $105,710, and less personal exemption of $1,980). Your client's federal income tax for 2006 on $92,310 will be $20,178. This will be $4,846 more than the taxes of $15,332 that he would have paid on taxable income of $75,000 if he had not received the $100,000 distribution from his IRA and contributed it to charity.
Observation: In Example 1, the $15,000 of charitable contributions that could not be deducted in 2006 would be carried forward to be deducted in 2007. This would lower your client's taxable income and income taxes in 2007. In effect, part of the taxes paid in 2006 would be recovered in 2007.
However, the increase in taxable income in 2006 resulted in more of your client's income being taxed at a 28 percent rate, and the increased reduction in 2007 would save taxes mostly in the 25 percent bracket. Also, no part of his itemized deductions or personal exemption that were lost in 2006, because his adjusted gross income exceeded $150,500, could be carried forward to be used in 2007.
The Pension Protection Act of 2006 provides a method for taxpayers who are at least 70-1/2 to make contributions from their IRAs directly to charities without increasing their AGI. Individual taxpayers will be able to exclude from gross income up to $100,000 of otherwise taxable IRA distributions that are qualified charitable distributions. Such distributions from an IRA will not be subject to any percentage limitations on making contributions, since they will neither be included in gross income nor be claimed as an itemized deduction on the taxpayer's return.
Since such a distribution is not includible in gross income, it will not increase AGI for purposes of the phase-out of itemized deductions, personal exemptions or any other deduction, exclusion or tax credit that is limited or lost completely when AGI reaches certain specified levels.
To be a qualified charitable distribution, the distribution must be made after the IRA owner attains age 70-1/2 directly by the trustee of his IRA to 50 percent charities other than a private foundation as defined in IRC § 509(a)(3), or a donor-advised fund as defined in IRC § 4966(d)(2).
Also, to be excludible from gross income, the distribution must otherwise be entirely deductible as a charitable contribution deduction under IRC § 170, without regard to the percentage limits on charitable deductions. Thus, if the deductible amount is reduced because of a benefit received in exchange, or if a deduction is not allowable because the donor did not obtain sufficient substantiation, the exclusion is not available for any part of the IRA distribution.
Example 2: The same facts apply as in Example 1, except that your client has the trustee of his traditional IRA contribute $100,000 from the IRA directly to your client's college. As a result, no part of the amount contributed will be includible in your client's gross income for 2006. Your client's itemized deductions and personal exemption for 2006 will be the same as they would have been if no amount had been distributed to his college from his IRA, his taxable income will remain at $75,000, and his federal income taxes for 2006 will be $15,332, or $4,846 less than the $20,178 he would have to pay (as shown in Example 1) if he had taken the distribution from his IRA himself, and then contributed the amount distributed to his college.
If the IRA owner has an IRA with nondeductible contributions, the distribution is treated as consisting of income first, up to the aggregate amount that would be includible in gross income if the aggregate balance of all IRAs having the same owner were distributed during the same year. The annuity rules of IRC § 72 under which a pro rata part of the distribution would be treated as made out of nondeductible contributions don't apply.
However, proper adjustments must be made in applying the annuity rules to other distributions made in the tax year and later tax years to reflect the amount treated as a qualified charitable distribution.
Example 3: The same facts apply as in Example 2, except that $50,000 of the $500,000 in your client's traditional IRA consists of nondeductible contributions. If $100,000 is distributed to your client and then contributed to his college, only $90,000 will be included in his gross income (90 percent of the total distribution).
On the other hand, if the $100,000 is transferred directly by the IRA's trustee to your client's college, the entire $100,000 will be treated as coming from earnings and deductible contributions, no part will be included in your client's gross income, and $50,000
(12.5 percent) of the $400,000 amount remaining in the IRA will continue to consist of nondeductible contributions.
Thus, if your client takes a distribution of $5,000 from the IRA in 2006, in addition to the $100,000 contributed directly from the IRA to his college, only $4,375 (87.5 percent of $5,000) will be includible in his gross income.
Required minimum distributions
Even though a direct distribution from a traditional IRA to a charity is not included in the taxpayer's gross income, it is taken into account in determining the owner's required minimum distribution for the year.
Thus, if the amount distributed directly from the IRA to an eligible charity at least equals the amount of the owner's required minimum distribution for the tax year, he will not be required to take any additional distribution for that year. Thus, the amount of the required minimum distribution will not increase his AGI.
Observation: For some comparatively low-income taxpayers who must take required minimum distributions from their traditional IRAs, and who also make charitable contributions, having a charitable contribution made directly from the IRA to a charity may reduce the amount of their Social Security benefits that have to be included in their gross income. This is so since their AGI will be lower if all or part of their required minimum distribution is made directly to the charity from their IRA.
Transfers from Roth IRAs
The rules described above also apply to transfers from Roth IRAs to charities. However, in the case of a Roth IRA, this would be important only if the amount distributed from a Roth IRA was not eligible for exclusion from gross income because it was made before the end of the five-year period starting with the year a contribution was first made to the Roth IRA.
Observation: Presumably, if any amount contributed directly from an IRA (traditional or Roth) to a charity consists of nondeductible contributions, the taxpayer should be able to claim an itemized deduction on his return for that amount.
Editor's Note: This marks Bob Rywick's 183rd and final regular column for Accounting Today. Speaking for the editorial staff and our readers, we owe Bob a huge debt of gratitude for his contributions over the past eight years and his part in elevating the quality of Accounting Today. His byline will be sorely missed.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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