How to Reduce Your Taxes on Your IRA RMD using QCDs

Originally written on Aug 2, 2018 and updated for tax law changes. 

If you are no longer working and have reached the age of 72, you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution (RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more, but this requirement is the minimum you must take or be severely penalized. Fortunately, this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)

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If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.

Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo. There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)

However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA), with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.  

How much you pay in taxes on your RMD partially depends on where your taxable income falls in the tax brackets; but how much you must withdraw (i.e., the amount of the RMD), which adds to your taxable income, is based on your age and your total IRA/401(k) account balances as of the end of the previous year. If you have a 401(k) and are not working, you will have to take an annual distribution that also includes those 401(k) assets in the calculation.

An RMD must also be taken on a Roth 401(k), even if there are no taxes to be paid. (Note: After retirement, it is often a good idea to roll over your Roth 401(k). The Roth 401(k) would be directly rolled to a Roth IRA. Any after-tax monies in your regular 401(k) can be converted and rolled into a Roth IRA too. Doing this avoids any RMD requirement on your Roth and after-tax savings, allowing the magic of compounded tax-free growth—not only for your lifetime, but stretched over the lifetime of your spouse and, eventually perhaps, up to 10 years for non-spouse beneficiaries.

The SECURE Act of 2019 limited the stretch of non-spouse beneficiaries to 10 years. So, Roth 401(k)s can be subject to the RMD rule; Roth IRAs are not.

(As for after-tax contributions in 401(k)s, the sooner you can rollover that 401(k) to a Roth IRA the better, so the interest starts accumulating in your tax-free bucket versus your tax-deferred bucket. If you are still working, ask about your company's in-service rollover policy.)

The RMD distributions are based on IRS life expectancy tables (Reference Uniform Lifetable II if your spouse is the sole beneficiary and more than 10 years younger than you. Else reference Uniform Lifetable III.)

Here is a short section of Lifetable III with RMD percentages calculated for perspective.  

At age 72, your RMD is 1/25.6th (or 3.91%) of the IRA value ending December 31st of the previous year. At age 79, it is 1/19.5th (or 5.13%) of the IRA value ending December 31st of the previous year. The divisor is your “statistical life expectancy”, so you are are dividing your IRA assets by the supposed average number of years someone your age is expected to live.

As you can see, the older you get, the percentage goes up, making it harder and harder for your rate of return to keep pace with your withdrawal. Eventually, if you live long enough, the portfolio will be virtually depleted--though the tables do give a generously-long life expectancy.

(The RMD method of spending down your retirement nest-egg to meet living expenses is not the best method. The taxes must be paid on the RMD, but the RMD does not have to be spent. At a certain point, the RMD, minus taxes, that is above your living expenses needs to remain invested for future years, albeit in a non-IRA, taxable account. All the RMD rule says is: this amount must come out of the IRA so taxes can be collected. For more on this, read How to Manage Cash Flow in Retirement.)      

Below, I plotted the percentages calculated from Lifetable III to show the rise with age (from 3.65% at age 70 to 52.63% at age 113).

There is not much wiggle room to escape the taxes on RMDs once they begin. Itemizing deductions could offset the taxes owed. But with the tax change of 2017 (starting in 2018), what can you do if you don’t itemize, but instead opt to claim the much higher standard deduction?

A qualified charitable distribution may be the answer. A QCD is not an itemized deduction, but a donation to a qualified charity (qualified per the same requirements as if it was a deduction). Instead of being an itemized deduction, a QCD comes right off your income on the 1040 form. If all requirements are met, it is possible that the QCD could, in essence, eliminate all taxes that would have otherwise been owed on the RMD.

There is a long history on this QCD tax provision, but fortunately, the PATH Act of 2015 finally made permanent the use of the QCD to lower taxes on the RMDs.

As Michel Kitces writes in his white paper entitled, Rules And Requirements For Doing A Qualified Charitable Distribution (QCD) From An IRA, “The core requirements for making Qualified Charitable Distributions (QCDs) from an IRA to a charity are contained in IRC Section 408(d)(8) (as created under Section 1201 of the Pension Protection Act of 2006). Under the QCD rules, the IRA owner must be at least age 70½ to do the QCD to the charity (and notably, the IRA owner must actually be age 70½ or older on the date of distribution, not merely turning 70½ sometime that year). Under IRS Notice 2007-7, Q&A-37, even a beneficiary of an inherited IRA can be eligible for a QCD, as long as the beneficiary themselves is at least age 70½ on the date of the distribution.”

If the IRA is not receiving any employer contributions (e.g., SEP IRA or SIMPLE IRA), each person can donate up to $100,000 as a single distribution from his or her IRA. The recipient cannot be a private foundation or donor advised fund.

The check from your IRA must be made payable to the qualified charity. It is more trouble and time-consuming to have the check sent directly to the charity, usually requiring a Medallion guarantee (a similar but more strict process than getting a notarized signature). For most people, the best path is to have the check made payable to the charity but mailed to the IRA owner, after which the owner can forward the check to the charity.

The benefit of using the QCD is that you can gift pre-tax dollars to the qualified charity of your choice. The donation comes out of the IRA without any of the tax consequences that would have otherwise applied. So, although the QCD is not a charitable deduction, it is excluded from your taxable income.

If you have started taking RMDs, beginning at age 72, the QCD is deemed to satisfy the RMD. Therefore, the QCD can be coordinated with your RMD to reduce or eliminating the taxes you would have otherwise had to pay on the RMD.

Now this works a financial benefit to you only if you would have given that money anyway and didn't or couldn't deduct it. If you itemize deductions you could still use the QCD instead, but why not just take the distribution into your own account and then declare the donation as a deduction. However, reducing your AGI for other financial reasons could tip the scales toward using the QCD. Where the QCD is extremely valuable is for people who don’t itemize deductions (and an estimated 94% of tax filers won’t itemize under the new tax laws). Those who don't itemize can still receive a tax break on their donation as a QCD.

Richard turned 72 years old this year and has an IRA with an ending value last year of $870,000. His RMD this year is 1/25.6th (or 3.91%) of $870,000 which equals $34,017. Richard would like to give $12,000 to his church this year. Instead of giving $1000/month as he normally would from his checking account, Richard donates a $12,000 QCD to his church, which satisfies $12,000 of his RMD obligation. He then pays taxes on the remaining $22,017 ($34,017 RMD - $12,000 QCD). Instead of having to pay income taxes on $34,017, he will only pay taxes on an $22,017.

Using this strategy, Richard and his wife Linda can claim the$26,500 standard deduction for married couples (plus $1,250 over age 65 per person additional deduction), and also reduce their taxable income by $12,000.If they are in the 24% tax bracket, they would save $2880 in taxes by implementing this strategy.The after-tax checking account money he would have given to his church can now be reallocated to living expenses and the $2880 tax savings from the QCD could buy them an extra vacation!

Here are some things to keep in mind regarding QCDs.

• Remember, you cannot make a QCD until you actually turn 70½. It does not qualify if you merely turned 70½ sometime that year.

• To count as a QCD that is not taxable, the check from the IRA custodian must be made payable to the charity, not the IRA owner.
  

• Your IRA custodian will require you to fill out and sign an IRA distribution form. On this form you should specify that the distribution is charitable and that the check is to be made payable to an alternate payee (i.e., to the charity versus yourself). Then have the IRA custodian send the check to you. After you receive the check, make a copy of it for your records and deliver it to your charity. Since your name is not on the check, you will not endorse it. Keep a copy of the signed distribution form with a copy of the check in your tax file.

• When you meet with your accountant to prepare your taxes, make sure he/she is aware of the QCD. Have a copy of the check attached to your 1099R if possible. Before signing or approving your return, be sure to verify the QCD is properly deducted from your income (on line 4b of the 1040 form). Unfortunately, IRA custodians often don't properly code the distribution on the 1099R as a charitable donation--so keep your records available and be sure to inform your tax preparer of the QCD, or he/she could miss it and you will miss out on the tax benefit.
  

• To be on the safe side, give the charity enough time to cash the check by the end of the year. Your sending of the check and the recipient receiving the check by year-end may not be enough to prevent an ornery IRS tax auditor from disapproving the QCD for the year you intended.
  

Example. Jim made traditional IRA contributions at age 71 and 72 for a total of $14,000. A few years later, Jim wants to make a qualified charitable distribution from his IRA of $20,000 to his church. The first $14,000 of the $20,000 distribution will not be treated as a QCD, leaving only $6000 as a QCD to reduce his taxes.