December 2006
NEW LEGISLATION: IRA WITHDRAWALS We are writing to advise you of a recent change in the tax law that represents an interesting opportunity for retirees. If you are over age 70½ and have Individual Retirement Accounts (IRAs) that require you to draw an annual distribution, it is likely that this new law change could offer significant tax savings. This memo will explain how you can arrange your required annual withdrawal from your IRA differently to gain these possible tax savings. The Law Change The Pension Protection Act, enacted August 17, 2006, allows the IRA of an individual over age 70½ to be directly transferred to charity without any inclusion in the taxable income of the IRA owner. Because the IRA income is sidestepped, there is also no charitable deduction. This law change is available for the 2006 and 2007 tax years. These tax-free transfers of an IRA to charity count toward the annual required withdrawal. But where’s the advantage if we are simply eliminating both reportable IRA income and an offsetting charitable deduction? Here are several situations that illustrate the opportunities. The non-itemizers Many retirees, especially those with modest incomes, use a standard deduction in lieu of claiming detailed itemized deductions that would include their charitable contributions. The standard deduction has been inflation-indexed annually, and for 2006 has increased to $12,300 for joint filers and $6,400 for a single filer retiree. As a result, in many cases the charitable contributions are of little or no tax benefit. Example 1 Retirees near the standard deduction.
Abe and Bev are both over age 70½ and drawing distributions from their IRAs. Their itemized deductions each year consist of about $4,000 of charitable contributions to their church, $4,000 of residential real estate taxes, and $4,500 of state income tax. These deductions, totaling $12,500, only slightly exceed the $12,300 standard deduction for 2006. Under the new law, Abe and Bev could arrange to have a $4,000 IRA withdrawal transferred directly to their church, in lieu of their regular charitable contributions. This would reduce $4,000 of IRA distributions they otherwise would have reported as income, saving over $1,000 of income taxes. Their deductions essentially stay the same, as the standard deduction provides the same result as occurred with itemizing in the past. But upper income filers also often get little benefit from charitable deductions. Phase-out rules eliminate itemized deductions as 1040 income increases over $150,000. If Abe and Bev had $400,000 of income, about $5,000 of itemized deductions are lost and they again become standard deduction filers. Directing IRA income to charity, in lieu of taking taxable withdrawals that can’t be offset by charitable deductions, can be an efficient solution.
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Significant charitable contributors Some generous retirees encounter the 50%-of-income limit on their charitable contributions, and as a result receive no tax benefit for current donations. The new law provides an alternative: Example 2 Taxpayer with charitable contribution carryovers.
Cal, a single retiree, has placed many of his investments in tax-exempt bonds. He enjoys a comfortable retirement income, but the taxable income in his Form 1040 is modest. As a result, Cal’s charitable contributions in the past have hit the 50% -of-income limit and are in carryover status to future tax years. Because of this, Cal’s current charitable contributions add to his carryover amount and produce no current tax savings. Under the new law, Cal can satisfy his current charitable giving objectives by making transfers directly from his IRA accounts to charities. These charitable transfers are not subject to the 50%-of-income limitation and will not add to Cal’s deferred charitable deductions. To the extent these IRA transfers represent distributions that Cal otherwise would have been required to take into income under the post-age 70½ minimum distribution rules, his taxable income is decreased. Avoiding phase-ins and phase-outs An unfortunate byproduct of taking any income into adjusted gross income (AGI) is the compounding effect of the phase-ins and phase-outs built into the tax law. If a taxpayer adds an extra $10,000 of income to AGI in a given year, the impact on the bottom line can far exceed the direct increase in income. Upper income filers will find that extra income phases out their itemized deductions and personal exemptions. Middle income retirees have an even greater risk through the phase-in of taxable Social Security benefits. Extra income of $10,000 can mean that as much as $8,500 of Social Security benefits become taxable. But if some of the required annual IRA withdrawal moves directly to charity, there might be a surprisingly large savings from eliminating the taxability of Social Security benefits. Example 3 Minimizing taxability of Social Security.
Dan and Evy are retirees who encounter 85% taxability of their Social Security benefits. Their gross Social Security benefits are $24,000 per year, and their other taxable income, including their minimum required IRA distributions, is $49,000. If Dan and Evy decide to transfer $5,000 of their IRA withdrawals directly to charity in order to decrease their taxable Social Security, they will reduce the reportable portion of their Social Security benefits by over $4,000, and save about $2,000 of total federal and state income taxes:
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With Full IRA Income Interest, pensions, IRA withdrawals Taxable Soc. Sec. ($24,000 gross) Adjusted gross income Total federal and state taxes $ 49,000 20,400 69,400 9,000
$5,000 IRA To Charity $ 44,000 16,200 60,200 7,900
$ $
$ $
Eliminating the $5,000 of IRA benefits has decreased Dan and Evy’s taxable income by over $9,000, thanks to the reduction in taxable Social Security. The $2,000 tax savings would occur even if their income was lower (such as $39,000 reduced to $34,000). Single filers may find an even greater savings, due to higher marginal federal tax brackets. Major charitable gifts Retirees who are considering a one-time major donation will want to consider using undrawn IRA funds rather than after-tax investments or savings. Example 4 Major charitable contribution.
Fern is a single retiree who has been approached by a charity to make a $100,000 contribution to its capital campaign. Normally, Fern would use investments such as bonds and bank deposits to fund major donations. But based on a current-year tax projection, a large charitable contribution would partially offset lower tax brackets, and also encounters the 50%-of-income limit. Fern instead contributes $30,000 from savings, as that amount of charitable contribution produces higher tax bracket savings. She funds the other $70,000 of the contribution by making a direct IRA transfer to the charity. By removing this undrawn income from her IRA, Fern has diminished the amount of minimum distributions that must be taken into income in subsequent years (because the minimum distributions are based on the current balance within the IRA). Also, in the event of Fern’s untimely death, the IRA has been significantly diminished so that there will be less undrawn taxable income that must be reported by her children, the IRA beneficiaries. The Rules for IRA-to-Charity Transfers As can be seen from the preceding examples, many retirees will find some tax savings from this new IRA-to-charity opportunity But as always, there are rules in the tax law that must be complied with to accomplish these transfers properly: The tax-free transfer of an IRA to charity is effective for 2006, and is set to expire after December 31, 2007 (but Congress may extend this privilege).
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The IRA owner must have attained age 70½ , meaning that the individual is subject to required minimum annual distributions from IRAs. However, any direct transfers to charity count toward this annual distribution requirement. Any individual taxpayer is limited to $100,000 per year of tax-free IRA-to-charity transfers. Amounts transferred from an IRA to charity are not subject to the percentage-of-income limitations. However, the normal receipts and documentation rules continue to apply. If a receipt is not secured for a contribution of $250 or more, or if the IRA owner receives a valuable benefit in exchange for the contribution, the IRA transfer is no longer tax free. If the individual’s IRA accounts include some after-tax investment, any transfers to charity are assumed to come first from the income portion, with all IRAs aggregated for this test. If the charitable transfers exceed the undrawn income portion of the IRAs, a charitable deduction is allowed for the portion drawn from tax basis. The charitable organization must be one to which tax deductible contributions are normally allowed, but cannot be a donor-advised fund or a private foundation. This privilege only applies to IRA accounts; it does not apply to SIMPLE IRAs or Simplified Employee Pensions or SEPs. These and other types of retirement plan accounts must first be rolled over to an IRA if a charitable transfer is contemplated.
Summary We believe this new IRA-to-charity rule contains opportunity for most over-age 70½ retirees. But you will need to take the initiative in directing some or all of your normal annual withdrawal to one or more charities. And, in some cases, an even larger withdrawal or full exhaustion of the IRA account may make sense. Please let us know if you have questions or if we can be of assistance.
Straley, Ilsley & Lamp P.C.