IRA Charitable Distributions No Panacea
The extension for 2010 and 2011 of IRA qualified charitable distributions may encourage your clients to include them in their financial planning. Yet while it is true that completing a direct contribution from an IRA is pre-tax, this is hardly unique to contributing from an IRA, and in reality other charitable contribution strategies may still be far more effective for many affluent clients.
The primary reason that direct contributions from IRAs have relatively little value is that, in fact, the charitable deduction received for a regular cash contribution to offset other income usually yields an almost identical result in terms of after-tax wealth available to the taxpayer. The difference between the two is primarily due only to the effects of higher adjusted gross income resulting from including a distribution from the IRA in taxable income, such as deduction and credit phaseouts and other thresholds, such that the charitable deduction does not quite perfectly offset the net impact of higher income.
Contrast this, though, with another popular charitable gifting strategy: donating appreciated securities. In this case, the taxpayer receives a charitable deduction to offset income, in the same manner as donating from cash or another income source. However, in addition, the individual gets to exclude the long-term capital gain attributable to the appreciation. The net result is a full pre-tax contribution and excluding capital gains from income, generating even more after-tax wealth. An example:
John, who is 74 years old, has (in addition to other wealth that he uses to maintain his standard of living) three accounts: a $100,000 IRA, a $100,000 checking account, and $100,000 of ultra-long-term appreciated stock with a near-zero cost basis. He wishes to contribute $100,000 to a charity.
Scenario A: John contributes $100,000 from his checking account. In return, he receives a $100,000 tax deduction, which can nearly offset all of the income from his IRA. The net result: Almost all of his IRA income is tax-free (we’ll assume he can spend $98,000 of it, with $2,000 owed in taxes due to a not-quite- perfect offset of the deduction), and his appreciated securities will be worth $80,000 after taxes. Final spendable wealth: $178,000.
Scenario B: John contributes $100,000 directly from his IRA to a charity, since he’s over age 70½. In return, he is able to exclude the entire $100,000 from income. He still has his $100,000 checking account available, and he still has $80,000 of after-tax value for his appreciated securities. Final spendable wealth: $180,000.
Scenario C: John contributes his $100,000 of appreciated securities to the charity, and since they’re a long-term asset, he’s able to exclude the entire amount of capital gains from income, while also still claiming a full $100,000 tax deduction. This allows John to almost fully offset his IRA income (again, we’ll assume he can spend $98,000 of it, with $2,000 owed in taxes due to the not-quite-perfect offset of the deduction), and he still has $100,000 in his checking account. Final spendable wealth: $198,000.
As the scenarios above show, there is some tax-efficiency value to completing a direct contribution from an IRA; the difference between scenarios A and B represents the benefit of having a direct exclusion of IRA income, instead of just trying to offset it with an outside charitable deduction. Nonetheless, it is still inferior to contributing appreciated securities, which results in far more final, spendable wealth.
The contribution of appreciated securities doesn’t always work out better. Charitable gifts of capital gain property, including appreciated securities, can subject the donor to lower annual deductibility ceilings (for a 50% charity, the ceiling is reduced to 30% of AGI, and for a 30% charity, it is reduced to 20%—see IRC §§ 170(b)(1)(C) and (D)); on the other hand, if the deduction is significant enough, it may still be worthwhile to contribute appreciated securities and carry forward the unused amount to a subsequent year. However, if the amount of capital gains to avoid is modest, and/or most of the charitable contribution will be carried forward (or worse, is even at risk of being carried forward until it is lost), the strategy may be less effective. If state taxation is involved and the state provides less favorable treatment of charitable deductions than the federal tax system, the direct IRA contribution may be preferable.
In the end, charitable contributions from an IRA should be viewed merely as a slightly more effective means of donating than contributing cash; contributing appreciated securities is still higher on the pyramid of tax-preferred giving.
By Michael E. Kitces, M.Tax., CFP, ChFC, (michael@kitces.com) director of research at Pinnacle Advisory Group in Columbia, Md., and author of The Kitces Report (www.kitces.com) and the blog “Nerd’s Eye View” (www.kitces.com/blog), where a version of this article first appeared.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919- 402-4434.
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