Article: Reducing Retiree Taxes


	Jeff Bither

December 2006

Reducing retiree taxes: IRAs to charity

The new IRA-to-charity rule presents tax-saving opportunities for many taxpayers over age 70½

Of all the recent tax law changes enacted by Congress, there is one that has the potential of reducing income taxes for nearly every retiree. Now, taxpayers over age 70½ are permitted to make a direct transfer from their individual retirement accounts (IRAs) to charity without reporting any taxable income on the IRA withdrawal. This change is effective now for the 2006 tax year and also applies for 2007.

At first glance, this may not seem like a major change. After all, if we take a taxable distribution out of our IRA and subsequently give those funds to charity, it would seem the reportable IRA income and the charitable deduction are simply a “wash” in our tax return. In reality, this rarely has happened. Here are a variety of illustrations to point out why the new opportunity of a direct IRA-to-charity approach is better.

Lower income filers. A key point is that these tax-free transfers of an IRA to charity count toward the annual required withdrawal that every retiree over age 70½ must take from their retirement accounts. Many retirees, especially those with modest income, use the IRS standard deduction rather than claiming detailed itemized deductions that include their charitable contributions. For example, for 2006, joint filers are given a standard allowance of $12,300, while a single filer retiree may claim $6,400. As a result, these taxpayers can use an IRA transfer to fund their normal church contribution, for example, and avoid the income they otherwise would have been required to take from their IRA. Yet they retain the same deductions due to the standard allowance.

Example. Al, a retiree, is required to draw about $5,000 per year from his IRA under the minimum distribution rules. Al also regularly contributes $3,000 to his church but does not receive any tax benefit because his standard deduction is greater than his total itemized deductions. If Al arranges for $3,000 of his IRA withdrawal to go directly to his church, he will cut his taxable income by $3,000.

Middle income filers. The greatest savings of using the IRA-to-charity transfer accrue to that large group of taxpayers who face the phase-in of taxable Social Security benefits. Under a complex tax formula, middle income retirees have an increasing portion of their Social Security benefits brought into taxable income as their other reportable income increases. Adding $10,000 of extra income can mean as much as $8,500 of Social Security benefits becoming taxable! But the formula goes the other way, also. Reducing IRA withdrawal income by a charitable transfer may also significantly reduce taxable Social Security benefits.

Example. Bill and Edna are retirees who collect $30,000 in gross Social Security benefits and have $36,000 of other retirement income (IRA withdrawals, interest and dividends, etc.). At these income levels, they are in the 85% phase-in range on Social Security benefits. Bill and Edna give $5,000 to their church annually and claim it as an itemized deduction. If they direct an IRA transfer to their church for this $5,000 contribution, they will have $5,000 less of IRA income but also $5,000 less in charitable deductions. However, $5,000 less of IRA income also means $4,250 (85%) less in taxable Social Security, saving them about $1,000 of federal and state income taxes.

Upper income filers. Upper income filers are typically claiming itemized deductions and may not appear to gain an advantage from accomplishing their larger charitable contributions through direct IRA transfers. However, greater income brings with it the many phase-outs of tax deductions and credits. For example, upper income filers lose a portion of their itemized deductions and personal exemptions merely by reason of the size of their income. Similarly, some tax credits become unavailable, and the likelihood of incurring Alternative Minimum Tax (AMT) is much greater. For these reasons, most upper income filers will benefit from direct IRA-to-charity transfers by decreasing the income portion of their return on which these various phase-outs are calculated.

Rules for IRA-to-charity transfers. There are several rules that must be followed to bypass your 1040 with an IRA-to-charity transfer:

The IRA owner must have attained age 70½ by the date of the transfer.
The privilege applies only to IRA accounts. Retirement plan funds and other types of accounts, such as SEPs, would first need to be rolled to an IRA before the charitable transfer may occur.
An individual is limited to $100,000 per year of tax-free IRA-to-charity transfers.
If an individual has some deductible and some nondeductible IRA accounts, any charitable transfer is first considered to come from the income portion, treating all IRAs as if pooled.
The charity must be a publicly funded organization; it cannot be a private foundation or donor-advised fund.
The charitable transfer is not subject to any percentage-of-income limitation, meaning that generous taxpayers who have previously encountered a limitation on their charitable gifts will not be limited on IRA transfers.
The normal charitable receipt and documentation rules continue to apply. Assuming the IRA-to-charity transfer is $250 or more, a receipt is required, and there cannot be any significant goods or services given back to the donor by the charity.

It seems clear that this new IRA-to-charity rule presents opportunities for many taxpayers over age 70½. If you have any questions about how it may apply to your situation, please contact your Schmidt Westergard & Company tax professional.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.