Journal of Financial Planning: October 2013
When the income limitation for Roth IRA conversions was lifted in 2010, most articles written on this topic made it appear that this “gift” from Congress was something that every individual with an IRA should take advantage of. If you did not, something was wrong with you or your financial adviser.
Similar to the Roth IRA conversion, gifting from an IRA is a great strategy … for some clients. You should not make the general conclusion that if your client makes charitable gifts and they are over the age of 70½ with an IRA, that they should be using their IRA to cover all of their charitable gifting. As a financial adviser, you need to fully understand and analyze your client’s specific situation. One size does not fit all when it comes to offering sound financial advice to your clients.
Background of Using IRAs to Fund Charitable Gifts
Let’s begin with a quick refresher on the rules surrounding making a qualified charitable gift from an IRA. This strategy first took effect in 2006, however, it seemed to never become a widely utilized strategy because it was never made permanent. Congress would always market it as a temporary tax break for a one- or two- year period. After this tax break would expire, Congress would always find a way to reinstate it for another year or two. Furthermore, I believe that this strategy lost some of its attractiveness in 2009 when Required Minimum Distributions (RMDs) were suspended for that year.
More recently, this strategy expired at the end of 2012. However in January 2013, Congress agreed to extend this provision for one more year (it is currently scheduled to expire December 31, 2013). The rule allows individuals who are at least age 70½ to gift up to a maximum of $100,000 per year from their IRA directly to a qualified charity. This distribution from your client’s IRA is not recognized as taxable ordinary income on their tax return, therefore reducing their Adjusted Gross Income (AGI). Keep in mind that the client does not recognize this charitable gift as an itemized deduction on their Schedule A.
When assisting clients with this strategy, make sure that the IRA custodian makes the check payable to the charitable organization and not to the IRA account holder. The custodian can mail the check to your client and your client can forward it to the charity. If the IRA distribution is made directly to the client (i.e., transferred to their bank account or a check made payable to the client) with the intent that the client will then write a check to the charity, it will not qualify as a direct gift to the charity and the distribution will be recognized as a taxable IRA distribution by the IRS.
You also should be aware that most IRA custodians will code the distribution (even though the check was made payable to the charity) as a taxable distribution on their Form 1099-R. The custodian does not want to take on the responsibility of determining whether or not the organization is a qualified charitable organization as defined by the IRS. This responsibility should remain with the client and their accountant. However, as the financial adviser, you should alert your client’s accountant that IRA assets were used to fund a charitable gift(s) so that he or she can reflect the correct taxable amount on the client’s Form 1040.
Who Should Use this Strategy?
Financial advisers should not automatically default to assume that if their client is subject to RMDs that all of their charitable gifts should be made from their IRA. The ideal situation or “sweet spot” for which this strategy is most appropriate is the client who meets one or more of these criteria:
- Does not need the cash flow from their RMD to meet their living expenses
- Does not have highly appreciated securities in their personal investment accounts
- Their charitable gifts exceed 30 percent of their AGI
- They take the standard deduction instead of itemizing, or their itemized deductions are subject to phaseout
- AGI is over the new Medicare surtax limit, subjecting their investment income to an additional 3.8 percent tax.
The phaseout of itemized deductions was not an issue for the prior three years; however, for 2013 (and beyond), this is an important factor that needs to be considered when developing a charitable gifting strategy for your clients. If your client’s AGI is above $250,000 (married filing jointly) or $200,000 (filing single), gifting from an IRA provides another strategy to help minimize your client’s exposure to the new Medicare surtax.
Using Appreciated Securities Versus IRA for Gifting
Assuming your client is eligible to make charitable gifts directly from their IRA, is it always better to make the gift from the IRA? Generally, an “above the line” deduction (a deduction that reduces your AGI) is better than a “below the line” deduction (i.e., an itemized deduction). However, if your client does not meet any of the criteria mentioned above, you may want to run the numbers, because gifting highly appreciated securities may provide more bang for your buck than gifting from the IRA.
For example, suppose your client is in the 25 percent marginal tax bracket and does not meet any of the “sweet spot” criteria mentioned earlier. If they gift $25,000 directly from their IRA, they will reduce their AGI by $25,000 and save $6,250 (25 percent x $25,000) in federal income taxes. If they gift $25,000 of highly appreciated securities (with a cost basis of $5,000), they will reduce their taxable income by $25,000 and also save $6,250 in federal income taxes. However, by removing the highly appreciated securities from their investment portfolio, they avoid having to eventually pay capital gains tax on the $20,000 gain and therefore save an additional $3,000 (15 percent x $20,000) in federal income taxes.
As mentioned before, it is vitally important to fully understand and analyze your client’s specific situation. As a financial adviser, you cannot base your recommendations on a rule of thumb. Although the numbers appear to make sense in the previous example, suppose your client is very old and may never have to sell that highly appreciated security to meet their living expenses during their remaining life expectancy. You may decide to gift directly from the IRA, because it is likely that the client’s children will inherit that highly appreciated security within the next couple of years. They would receive a step-up in cost basis on the security, allowing them to sell it with no income tax consequences.
There are many variables to consider when developing an appropriate gifting strategy for your clients. The Medicare surtax and reinstatement of itemized deduction phaseout are two additional variables that you need to take into account for 2013. Although there are only a few months remaining to use the strategy of direct gifting from IRAs, it is a tactic you should become familiar with so you can determine if it is suitable for your clients. As Congress has proven time and time again, we may not know if this provision will be extended for another year(s), made permanent, or let to expire at the end of this year.
Scott A. Michalek is a principal and senior financial advisor with Wescott Financial Advisory Group LLC in the firm’s Philadelphia office.