While working with an advisor to update her estate plan, Susan asked about charitable giving strategies. Because Susan has a significant amount of deferred taxable income in her IRA, her advisor suggested making qualified charitable distributions (QCDs) from her IRA. Also called charitable IRA rollovers, this technique can be particularly valuable if you don’t itemize deductions or if your adjustable gross income (AGI) is high enough to reduce the value of charitable deductions.

QCDs in a nutshell

At the end of 2015, Congress reinstated — and made permanent — charitable IRA rollovers. If you’re age 70½ or older and plan to make charitable donations this year, a charitable rollover can provide significant tax benefits. It allows you to transfer up to $100,000 per year directly from your IRA to a qualified charity without including that amount in your AGI.

Before QCDs, people who wanted to use their IRAs to fund charitable donations typically would take a taxable distribution, write a check to their favorite charity and deduct the donation on their tax returns.

The problem with this approach is that the charitable income tax deduction may not fully offset the tax on the distribution. For one thing, the deduction isn’t available at all if you don’t itemize, and some states don’t allow charitable deductions for state income tax purposes. Even if you itemize, charitable deductions are limited to 50% of your AGI for the year (or less, depending on the type of donation). Unused deductions may be carried over for up to five years and used to offset income in those years (subject to the same limits).

Another potential disadvantage is that taxable IRA distributions increase your AGI, which can:

• Increase taxes on your Social Security benefits,
• Trigger the 3.8% Medicare tax on net investment income, which kicks in after your modified AGI hits $200,000 ($250,000 for joint filers),
• Decrease your itemized deductions, which begin to phase out after your AGI reaches $259,400 ($311,300 for joint filers), and
• Raise your Medicare premiums.

Because it bypasses AGI, a QCD avoids all of these limitations. Plus, it applies toward your required minimum distributions (RMDs) for the year — a big advantage if you don’t need IRA funds for living expenses.

Understand QCD requirements

QCDs offer valuable benefits, but it’s important to understand their requirements to avoid costly tax mistakes. In addition to minimum age and maximum contribution limits, the requirements include:

Traditional or Roth IRAs only. QCDs aren’t available for inherited IRAs, IRAs that are part of a Simplified Employee Pension (SEP) plan or a Savings Incentive Match Plan for Employees (SIMPLE), or other employer-provided retirement accounts. It may be possible, however, to move funds from an employer plan into an IRA (through a tax-free rollover) and then use the IRA to make a QCD.

Eligible charities only. The donation must be received by a public charity, a private operating foundation or a “conduit” private foundation. Donations to private nonoperating foundations, supporting organizations and donor advised funds aren’t eligible.

Direct transfers only. The IRA must distribute the funds directly to the charity. If it makes the check out to you, it’s not a QCD, even if you endorse it over to the charity.

Deferred taxable income only. A QCD must consist of deferred taxable income — that is, funds that otherwise would be taxable if distributed to you. It doesn’t include distributions that are attributable to nondeductible contributions to a traditional IRA or to otherwise tax-free distributions from a Roth IRA. For this reason, Roth IRAs generally aren’t good candidates for QCDs, unless distributions would otherwise be taxable (for example, because the account is less than five years old).

Fully deductible gifts only. To be a QCD, a donation must be “otherwise deductible.” In other words, the gift would be fully deductible (without regard to AGI limits) had you made it with non-IRA assets. If you receive something of value from the charity in exchange for your gift, it’s not a QCD.

Acknowledgment required. The charity that receives the distribution must provide you with the same type of written acknowledgment required to substantiate other types of charitable donations. Failure to obtain the acknowledgment will invalidate a QCD.

Choosing the right strategy

After weighing the upsides and downsides of various charitable giving strategies with her advisor, Susan decided that QCDs made sense for her. But that may not be the case in your particular situation. Ask your advisor for more details on QCDs before taking action.