Tax-Saving Strategies for Charitably Inclined Retirees

Note: This video is part of Morningstar's February 2016 Tax Relief Week special report.

Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Congress made the qualified charitable distribution permanent in late 2015. Joining me to discuss the QCD is Michael Kitces--he's a financial-planning expert.

Michael, thank you so much for being here.

Michael Kitces: Great to be here. Thanks.

Benz: Let's start with the qualified charitable distribution. This is something that Congress made permanent at the very end of 2015. So, this is news for a lot of charitably inclined retirees who are taking required minimum distributions from their accounts. Let's talk about the QCD--what it is exactly and why it can be a valuable maneuver.

Kitces: The QCD, or qualified charitable distribution, rules from our IRAs are rules that allow us to take money directly from an IRA and move it or donate it to charity. It's kind of the perfect tax wash. You don't report the IRA distribution in your income; you don't take a charitable deduction for the contribution, but that's only because, by definition, you just took money entirely pretax out of your IRA.

Now, there are some limitations to it. You have to be over age 70 1/2 when you actually do the qualified charitable distribution. So, it's not just the year you turn 70 1/2--you have to have actually hit that 70 1/2 birthday. You can only do it up to $100,000 in a particular year. But the flip side is it also satisfies any RMD requirements you have for the year. And of course, if you have to be over age 70 1/2 to do it, you will have some RMD obligations for the year as well.

So, this has become really popular as kind of the kill-two-birds-with-one-stone strategy: "I wanted to make some charitable contributions anyways and I had an RMD anyways, so I can move the money directly from the IRA, donate it to the charity, I satisfied my RMD, and I get my pretax charitable benefit by just pulling the dollars directly out of the IRA and sending them over."

Benz: So, do I let my charity deal with my IRA provider on that transaction? I'm not taking the money myself and acting as sort of a conduit, am I?

Kitces: You are not supposed to take the money yourself. The IRS rules have actually been pretty clear. If the money comes out of your IRA and it's payable to you, it's treated as a distribution to you. If you go and now write a check to your charity, you have a taxable distribution. If you wrote a check to the charity, you'll get a charitable deduction that will partially offset it, but you don't really get the benefit of the rules. For the full benefit of the rules, the money should be payable directly from the IRA to the charity.

You are still, as the IRA owner, going to have to initiate that; of course, no one else gets to take money from your IRA. You have to initiate that process. But when you request the IRA distribution from your IRA provider, you are going to tell them, "I'm making a distribution to a charity--here's the charity it's going to." The key thing is to have them make the check payable directly to the charity. The IRS rules said if you'd actually like to hold the check and hand it to the charity, that's OK. But the check has to be payable to the charity, not payable to you and you endorse it forward or write them a new one. The check should be payable directly to the charity and, ideally, you can just mail it to them directly as well.

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Benz: Good point of clarification. Let's discuss why that QCD will tend to be preferable to actually taking that distribution, putting it in my account, and then writing the check to the charity.

Kitces: The reason that QCDs tend to work better than just doing charitable contributions is because of the way our deductions offset our income. So, if I just take my normal RMD for the year--I take out $2,000 and then I have income of $2,000--if I was making a charitable contribution of $2,000, I am going to get a $2,000 deduction. And a lot of people just think of it as, "Well, I have $2,000 of income and $2,000 of deductions--those will offset each other." And while they get pretty close to offsetting most of the time, it's not a perfect offset for everyone, and the reason is how we do our tax calculations now.

When I take my money out of my IRA, it's treated as income. It's what we call above-the-line income, so it increases our adjusted gross income, which triggers a lot of other stuff. It impacts the threshold for deducting our medical expenses and for our miscellaneous itemized deductions. It impacts a lot of special tax credits and benefits for retirees, in particular. It impacts your Social Security and how much of it is taxable if you haven't already hit the maximum cap. So, we get into the scenario where I take out my money from my IRA and it creates income, which also adversely impacts some phase-outs, phase-ins, and other thresholds. Then, I make my charitable contribution, but that's what we call an itemized deduction or below-the-line deduction.

So, they don't always perfectly offset each other because of all the indirect effects that happen when we add money to AGI above the line and then try to get deductions below the line. So, it's usually pretty good; but we find that when taking an RMD and writing a check to charity, sometimes we only get $0.98 on the dollar of tax benefit--or $0.97 or $0.95. So, it's not horrible, but it's often not the perfect dollar-for-dollar offset, whereas when we just do a QCD directly from the IRA to the charity, one dollar comes out and we get a dollar pretax. It's sort of that perfect offset.

Benz: So, retirees really like these QCDs. I've talked to a lot of retirees who are very enthusiastic that this is now a permanent provision. But let's talk about other maneuvers that charitably inclined retirees could use. You say a big one that some folks may overlook is this idea of taking appreciated securities out of a taxable account and sending them straight to charity.

Kitces: This is a big one that we find is overlooked. We go through this often with our clients as well. People are really excited about the qualified charitable distribution rules--and particularly, that they are permanent. Certainly, we think it's fantastic that they are permanent because, for years, we've gone through this process where we had them and then we lost them. We didn't even know if we were going to keep them for the year. Then, we would fix it, but retroactively at the end of the year. And of course, everyone is stressing about taking their RMDs and not wanting to wait until the last minute.

So, permanence for QCDs is a huge plus. And certainly, for anybody who was going to have an RMD anyway who wanted to donate to charity anyway, there is really no reason not to do the QCD to satisfy your charitable giving. At worst, it's a wash and it was going to be the same as just writing a check to the charity. And often, it's at least a couple of cents better for every dollar that you are donating.

The caveat to all of that is QCDs aren't really what I call the best strategy for charitable giving. The best strategy is donating appreciated securities, which is just a fancy label for investments you own in an investment account or a brokerage account that have gone up in value. So, the normal challenge we have anytime we own investments that go up in value is that we owe capital gains taxes: I bought it for $10,000 and it's gone up to $12,000, so I've got a $2,000 gain I'm going to have to pay capital gains taxes on.

The virtue of donating appreciated securities is that the tax code lets us do basically what I call a "double-dipping tax deduction." So, if I donate my $12,000, not only do I get a charitable donation for $12,000, I also get the donation and make that $2,000 capital gains bill vanish. So, for $12,000 of an investment that's gone up in value, I can't even use all $12,000 of that; I only get $12,000 minus my capital gains taxes. But if I donate it, I get the value for the full $12,000 and I make the capital gains bill disappear.

So, as a result, what we find is that for any particular charitable giving that you are going to do, the best way we can actually do it is by satisfying that charitable gift with some investment that's gone up in value. And frankly, we cherrypick. Whatever investment we can find, there has to be long-term capital gains to get the full benefit. So, we have to have held it for more than a year. But whatever thing we've got that's a long-term capital gain in an investment account that's got the most appreciation will give us the most bang for our buck. We get a full charitable donation for the value, and we make that capital gains bill disappear. So, we get the whole tax benefit for money we wouldn't have even gotten to use ourselves.

Benz: This is money, though, that needs to come out of a taxable account. If most of my retirement kitty is in an IRA or something like that, this mechanism is really not going to help me.

Kitces: Correct. It doesn't help unless you've actually got investments in a taxable account. You actually need something that's up as well: If your investments are flat or if that holding is down, this doesn't work. Again, you can cherrypick the one investment or even just the individual lots of an investment to find the thing that's up the most and will give you the biggest bang for your buck. But you need something that has appreciated in value for this to be worthwhile at all.

But once we find something that's appreciated in value, we can rank them in order then. So, if I've got a couple of thousand dollars I'm going to donate, the number-one benefit is donating appreciated securities. A distant number two--and the bigger your capital gains, the more distant it is--is doing a qualified charitable distribution from an IRA. And then number three, a little ways below that, is writing a check, donating cash, or contributing outright.

Benz: That's a good hierarchy. I don't want to take us too far afield, but just a follow-up question on these appreciated securities in a taxable account: Another thing that people might think about is what about leaving these to my heirs. That would be another avenue to get that gain out of a portfolio, correct?

Kitces: Correct.Ultimately, we have a couple of different ways that we can basically get our gains tax-free. Number one is we hold them until we pass away and get a step-up basis. Then, number two is donating them and donating appreciated securities as well. We find, often, that this just kind of comes down to a time horizon of--not to be morbid--but how close are we to the point of getting a step up in basis? I don't want to hold on to an investment and then find out I need to change it for investment purposes and now need to pay the capital gain because it was too risky from an investment perspective to hold until someone was going to pass away and get the step up in basis.

So, often, we'll cherrypick on that basis alone of just trying to decide which investments we want to grab--certainly, anything that we are more likely to sell in the first place. And sometimes we'll even pair this together. If we want to donate the appreciated securities, we might put them into a donor-advised fund so that we can get the tax deduction now for the full value and liquidate them to reinvest--however we want to change the investments--then make the donation to the charity down the road, whenever it is that we are ready to pull the trigger.

Benz: Michael, valuable insights as always. Thank you so much for being here.

Kitces: My pleasure. Thank you. 

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