Seniors: A New Way to Give

Updated on January 31, 2007.

IF YOU'VE REACHED age 70 1/2 and are feeling generous of spirit, new tax rules surrounding charitable distributions from an IRA could spell a nice donation for your charity of choice — and a terrific tax break for you.

Thanks to a change included in the recent Pension Protection Act (enacted earlier this year), you can make cash donations to many tax-exempt charities directly out of your traditional or Roth IRA and receive a 100% deduction on your distribution, without having to worry about restrictions that can reduce or delay itemized charitable write-offs. And that's not the only tax perk it offers. Here's what you need to know.

Eligible Distributions
To qualify, your distribution must be a "qualified charitable distribution." This means a payment of an otherwise taxable amount, by the trustee of your traditional or Roth IRA, directly to a qualified public charity.

The new qualified charitable distribution rule is only available for IRA payouts during 2006 and 2007. No more than $100,000 can be treated as qualified charitable distributions in either of those years (for combined total of no more than $200,000 in the two years). If you fail to use up your entire $100,000 privilege this year, you won't get another chance unless Congress extends the break.

Understanding the Income Tax and Estate Tax Benefits
Qualified charitable distributions are not included in your adjusted gross income (AGI). This lowers the odds that you'll be affected by various unfavorable AGI-based phaseout rules — such as those that can cause you to lose part of your itemized deduction write-offs (including those for charitable donations), personal exemption write-offs, and so forth. In addition, you don't have to worry about the 50%-of-AGI limitation that can delay your itemized deductions for cash donations to public charities. (See "The Tax Perks of Charitable Giving.")

Another potential perk: A qualified charitable distribution from a traditional IRA counts as a payout for purposes of the required minimum withdrawal rules. Therefore, you can arrange to donate all or part of your 2007 required withdrawal amounts (up to the $100,000 annual limit for qualified charitable distributions) that you would otherwise be forced to receive and pay income taxes on.

If you own one or more traditional IRAs to which you've made nondeductible contributions, part of your IRA balances are taxable amounts (from your deductible contributions and account earnings) and part are nontaxable amounts (from your nondeductible contributions). In this situation, qualified charitable distributions are treated as coming from taxable amounts first. This is contrary to the "normal" rule that says your IRA distributions are treated as being partly taxable amounts and partly nontaxable returns of your nondeductible contributions.

Being allowed to pull out taxable amounts first for qualified charitable distributions works to your benefit. Why? Because it allows you to completely avoid taxes on otherwise taxable amounts that are distributed from your IRA(s) to charity, while leaving nontaxable amounts in your IRA(s) that you or your heirs can withdraw tax free later on. Last but not least, qualified charitable distributions will reduce your taxable estate.

Here's an Example
Say you're a financially comfortable 72-year-old individual. You have $120,000 in traditional IRA A, and $90,000 in traditional IRA B, for a combined total of $210,000 in the two accounts. You've made a total of $35,000 in nondeductible contributions to the two accounts. The remaining $175,000 is from deductible contributions and account earnings.

Before the end of 2007, you decide to take advantage of the new qualified charitable distribution rule by donating $100,000 out of IRA A (leaving a balance of $20,000 in that account).

The qualified charitable distribution is treated as coming out of the taxable portion of your IRAs. So after the distribution, your IRA balances total $110,000 ($20,000 in IRA A and $90,000 in IRA B). Of that $110,000, $75,000 is taxable money (the original $175,000 minus the $100,000 donated to charity), and $35,000 is nontaxable money (the entire amount of your nondeductible pay-ins).

The $100,000 qualified charitable distribution is more than enough to fulfill your 2007 required minimum withdrawal obligation for your IRAs, but you owe no federal income tax. This equates to an immediate 100% write-off for the $100,000. In addition, your required withdrawal obligations for future years have been substantially reduced. Why? Because the amount of money in your IRAs has been reduced by $100,000. Also, you still have the entire $35,000 of nontaxable money in your IRAs, which you or your heirs can withdraw tax free later on. Last but not least, you've lowered your taxable estate by $100,000.

Does This New Rule Work for You?
The qualified charitable distribution rule is beneficial for seniors in the following circumstances:

But Mind These Caveats
Federal-income-tax-free qualified charitable distribution treatment only applies when the entire amount that is distributed from your IRA would otherwise be fully deductible under the "normal" rules for itemized charitable donations (ignoring the itemized deduction phaseout rule and the 50%-of-AGI limitation). This means if you receive any benefit from a charity that would reduce your deduction under the "normal" rules (such as free tickets to a banquet honoring generous folks like you), forget about getting the desired federal-income-tax-free treatment for your IRA distribution.

Also, you can't take advantage of the qualified charitable distribution rule for payouts from a SEP account, or a SIMPLE IRA, or any other type of tax-favored retirement plan account.

Finally, the idea of taking qualified charitable distributions out of a Roth IRA is not nearly as attractive as taking such distributions out of your traditional IRA(s). Why? Because you and/or your heirs can take federal-income-tax-free Roth IRA withdrawals after the account has been open for at least five years. So with a Roth IRA, the only obvious advantage to the qualified charitable distribution strategy is that it will reduce your taxable estate.

Bottom Line
The new qualified charitable distribution break can be a tax-smart move for well-off seniors. However, you would be wise to check with your tax pro before pulling the trigger.