Donating required minimum distribuions to charity has tax advantages

RMDs are a required distribution from certain tax-favored accounts that must begin at a legally defined age, and they must also meet certain minimum size requirements. RMDs are generally applicable to:

• Traditional IRAs
• 401(k) and profit-sharing plans
• 403(b) and 457(b) plans
• SIMPLE IRAs and SEPs

All of these retirement plans feature tax-deferral provisions. This means that no money held within the plan is subject to taxation on an ongoing basis. This feature allows you to (theoretically) grow a large nest egg over your working career.

The asset growth is not hindered by having to pay taxes on gains, interest or dividends. Besides this, these retirement accounts also feature the deductibility of contributions, or deferral of income tax in the case of a 401(k).

This means that not only are the investment gains tax-deferred, but the amounts that are deposited are also either deductible or shielded from current taxation. These two features explain the popularity of qualified retirement plans as an employee benefit.

However, nothing is truly free, as they say. The government isn't willing to let you avoid paying taxes on these dollars forever. The RMD provisions ensure that you end up paying taxes on them at some point in time.

Prior to 2020, RMDs were generally required to begin at age 70 1/2, with a few exceptions for people who hadn't retired by that time. After 2019, the beginning age was changed 72, and you can still delay taking your RMD if you're actively employed at age 72 and beyond.

RMDs are calculated by formula. You divide your total account balance subject to RMD by a life expectancy factor. The idea is that you are forced to distribute a relatively consistent amount of money over the rest of your life. The IRS provides the formulas needed to determine your RMD each year.

RMDs are generally unpopular because they cause two inter-related consequences: the amounts distributed are taxable, and the taxable amounts are added to your adjusted gross income, which often puts you into a higher tax bracket than you would otherwise be.

This can be a big cause for concern since many traditional retirement planning strategies assume that you will be in a lower tax bracket during retirement. However, if you have a significant nest egg built up, your RMDs can potentially push you into a higher tax bracket than you were in during your working career. While this is somewhat unlikely, it can't be ignored in your planning, especially for aggressive savers who experience large and steady investment gains over time.

Fortunately, there are some strategies available to lower the tax hit due to RMDs. Two popular strategies are:

• Making a qualified charitable distribution (QCD)
• Contributing to a donor advised fund (DAF)

While both of these strategies come with tax benefits, they work in a totally different manner.

A qualified charitable distribution is a distribution taken from an IRA and sent directly to a charitable organization. Making this kind of distribution has a huge impact on your tax situation. When you do this, the distributed amount is NOT added to your taxable income.

Note that you can't make a QCD from a 401(k) plan. However, you can roll your 401(k) over to an IRA and then make your QCD from there (without incurring any tax consequences).

Since the distributed amount isn't added to your taxes, you benefit in two ways:

• You don't pay taxes on the distributed amount.
• The distributed amount doesn't push you into a higher tax bracket, so you won't pay more taxes on your other income.

In other words, the QCD strategy completely mitigates the negatives of RMDs, which can be welcome news to many investors.

There are a few restrictions on the use of QCDs. For one thing, the maximum amount is $100,000 per year. If your RMD is larger than this, you'll have to claim any amounts over this limit on your taxes, which can negatively impact your taxes.

Only certain kinds of charity are eligible for QCD treatment, including operating public charities that meet the requirements of 501(c)3. You can't make a QCD to a donor advised fund (which we'll discuss shortly).

It is very important to remember that the money needs to move directly from your IRA to the charity. If you receive the distribution personally, it will be considered a taxable distribution and you'll lose the benefit of the QCD.

You might be wondering, are charitable donations from RMDs tax deductible? Unfortunately, the answer is no. You can't deduct the amount given.

The biggest negative to this strategy is that you have to give away the money. You will no longer have the use of it. If you're set financially, and you truly don't need the money, then a QCD can be an excellent way to not only reduce your tax burden, but meet some of your philanthropic goals, too.

On the other hand, donating the money may not be a great idea if you might need the funds for:

• Current income to meet your living expenses and retirement lifestyle
• Part of your estate plan to distribute assets to your heirs in the future
• Savings for a “rainy” day in the future, even if you don't have an immediate use of the money right away

In short, be absolutely sure you don't need the money before you commit your RMD to charity.

QCDs are reported on Form 1099 since they are a distribution from a tax-advantaged account. According to the IRS, you will report the entire distributed amount on your 1040, but indicate that the QCD is not subject to tax (up to the $100,000 minimum).

The second tax-favored strategy is to make a tax-deductible donation to a donor advised fund (DAF). A DAF is a fund that holds, invests and accumulates funds dedicated to charitable causes. Funds are distributed from the DAF under your advice. However, the charity organization has legal control over the funds and ultimately makes the decisions as to how the funds are dispersed.

When you use this strategy, this is the chain of events you'll be undertaking:

• Take your RMD from your IRA
• Send your donation to the DAF
• Report the full RMD as taxable on your income taxes
• Deduct the amount of money contributed to the DAF

This method isn't as tax-friendly as the QCD since you have to recognize the distribution as taxable income. However, you are able to deduct the amount that you gave to the DAF. To take advantage of this, though, you'll have to itemize your taxes.

One of the more interesting benefits of DAFs is that they allow your funds to accumulate over time. Since the funds can be invested for growth, your donations can grow with interest and capital gains over time. This could multiply the impact of even a single contribution to a DAF.

This accumulating feature also allows you to structure a giving strategy that can be implemented over the course of your lifetime. Additionally, you are allowed to recommend the ultimate uses of your donation. You might advise that your accumulated donations be given to several different charities, for example.

You can even utilize both strategies for giving, which might be useful if your RMDs exceed the $100,000 limit. You can make a qualified charitable distribution and also make a tax deductible contribution to a donor advised fund. Just make sure that they are two totally separate transactions; you can't use your QCD funds as part of your tax-deductible DAF contribution.

Making charitable donations with your required minimum distributions can be a great way to optimize your tax situation and make a difference in the world. However, if you're estate plan isn't funded to the point where you can give away such large sums of money because you want to pass on assets to your family, you can consider different strategy.

As long as you have enough income and assets to meet your needs and goals during the rest of your retirement, you can consider gifting some or all of your RMDs to your children or grandchildren. To make this as tax efficient as possible, you'll probably want to consider staying within the annual IRS gift tax exclusion ($16,000 per person for 2022, or $32,000 for a couple), but you should definitely consult with your tax advisor to determine the optimal amounts.

The bad news here is that you'll suffer the negative consequences we mentioned before: The distribution itself is taxable, and it might increase your overall income to such an extent that you move up into a higher tax bracket. This has the effect of increasing your overall taxation.

But, if you want to make the best of a bad bargain, you can use this forced distribution to help accomplish some of your estate planning goals.

How? Consider using some or all of your RMD each year to fund an asset or assets for your kids and grandkids. To maximize the tax efficiencies of these distributions, consider funding annuities or life insurance contracts for them. By funding these types of assets, you can ensure:

• That they don't have to pay taxes on interest or dividends credited to their policies because these vehicles are tax-deferred.
• If you fund life insurance, you can make sure they have life insurance in place while they're young and insurable.
• If some or all of the funds are used to fund life insurance, and one of them dies, the death benefit is usually tax-free, so their beneficiary would receive the proceeds without having to pay any taxes.

Besides the insurance protection features, systematically funding these products can mean that funds accumulate tax-deferred for years, even decades. The funds can even continue growing after your death.

The accumulated funds can potentially be accessed for any of these compelling reasons:

• To protect their families from financial harm
• To provide cash for college educations
• To provide help buying a home or other real estate
• To provide cash for starting a business

You can of course use your RMDs to fund non-insurance accounts like brokerage accounts, but investment growth in these accounts will be taxable to the people you gift them to.

Regardless of whether you will give away your RMDs, or use them to enhance your personal finances, it's crucial to make sure you're working with a sound plan. To make a comprehensive and effective plan, make sure you're working with an advisor who is experienced in this kind of retirement cash-flow planning.

As you get closer to RMD age, review the state of your finances in light of your retirement and estate planning goals. From this baseline you should be able to determine if you have the ability to contribute your RMDs to charity, give them to your heirs, or if you'll need them for cash flow.

As your choice becomes obvious to you based on your review, work with your advisor to find the charities and, or, products you'll need to execute your plan. If you're giving funds to your family as gifts, make sure your advisor is experienced with the kinds of annuities and life insurance policies that are used to optimize cash accumulation.

Once you've made your plan, be sure to review it frequently. If your cash flow needs change further in the future, make sure you have a strategy for dealing with them so that you don't derail your retirement by over-giving.