Taxpayers naturally seek to use benefits offered in the Internal Revenue Code. Sometimes, though, Code provisions offset each other, reducing the expected tax savings. That’s often the case with certain deductible IRA contributions and qualified charitable distributions (QCDs). Fortunately, savvy planning can help seniors receive the best of both worlds.
IRA deductions. In 2023, anyone with earned income can potentially deduct traditional IRA contributions up to $6,500, or $7,500 for those age 50 or older, if modified Adjusted Gross Income (MAGI) is below the phase out limits. A worker’s spouse also may make these deductible contributions. The former rules, which prohibited IRA deductions once someone reached age 70-1/2, were repealed a few years ago. Nevertheless, various hurdles to clear may reduce the maximum tax deduction for anyone strategically using the new rule to make an IRA contribution at age 70 1/2 or older.
QCDs. Age 70-1/2 is still the entry point for generating QCDs. These transfers typically go from a traditional IRA directly to a qualified charity or charities. QCDs don’t provide tax deductions but they also don’t trigger taxable income. Thus, they offer seniors a way to gain some tax relief even if they don’t take an itemized deduction for charitable contributions. In addition, QCDs satisfy required minimum distributions (RMDs). For the many taxpayers who don’t itemize deductions, a QCD can actually add to the standard deduction, in effect delivering the standard deduction plus a charitable contribution deduction.
How IRA contributions and QCDs collide
What problems might arise if a working senior contributes to an IRA and also initiates QCDs in the same year? QCDs must be reduced by IRA contributions deducted after age 70-1/2, up to the amount of IRA deductions that already have been used to reduce QCDs. These hypothetical examples can illustrate the impact:
Joe Blake, age 75, qualifies for a $7,500 IRA contribution so he puts that much into his account this year. Joe already has made a $10,000 QCD from this IRA. To keep things simple, assume that Joe has never made QCDs before and had not taken any deductions for IRA contributions since age 70-1/2, before doing so in 2023.
Here, Joe’s $7,500 tax deduction would offset $7,500 of his QCDs for the year. He still would be entitled to a $7,500 tax deduction for his IRA contribution, so his IRA would include that $7,500 of pretax money. However, this tax-favored $7,500 would be removed from Joe’s QCD total. Only the difference--$2,500—would be counted as an untaxed QCD and the $7,500 balance would be included in his taxable income for the year. This calculation is designed to prevent Joe getting a double tax break for the same dollars.
Moreover, IRA contributions after age 70-1/2 must be aggregated to offset all QCDs, and the excess carried forward. Suppose Joe’s 77-year-old sister Irene has made $18,000 in IRA contributions in the past three years without taking any QCDs. Irene wants to generate $15,000 of QCDs this year.
Irene will get no tax benefit from those QCDs this year, in this example. All $15,000 moved from her IRA to charities will be included as taxable income. The $3,000 of unmatched IRA deductions will be carried forward, to reduce $3,000 of QCDs in the future.
Going forward, ongoing aggregate IRA contributions after 70-1/2 and QCDs will be tracked. Only when QCDs exceed post-threshold IRA contributions will the difference be treated as an untaxed QCD for any given year.
Masterful moves over age 70 ½
Don’t let this parlay turn into a tax trap. Instead, consider these savvy advanced planning ideas that can help deliver desirable results:
Avoid traditional IRAs. Use other tax-favored retirement accounts instead. Contributions to an employer-sponsored plan such as a 401(k) can provide tax deferral without interfering with QCD tax treatment. Alternatively, other forms of IRAs might be used, such as SEP and SIMPLE IRAs. Deductible contributions to such accounts won’t offset QCDs from a traditional IRA already in place.
As yet another tactic, after-tax plans such as Roth IRAs can be targeted without devaluing QCDs.
With acceptable income (MAGI under $153,000 for single filers in 2023, for example), a full contribution to a Roth IRA is possible, if earned income is sufficient that year. Contributions are after-tax, future distributions may be untaxed, and QCDs from the taxpayer’s traditional IRA will qualify if there were no deductible contributions after age 70-1/2.
For seniors whose income is too high for Roth IRA contributions, a backdoor Roth might be a viable strategy: make a nondeductible contribution to a traditional IRA and then convert some of those dollars to the Roth side for potential tax-free distributions in the future. To execute a backdoor Roth IRA contribution, a taxpayer uses IRS Form 8606, Nondeductible IRAs.
On Page 1 of this form, nondeductible contributions to a traditional IRA are reported, followed by a report of Roth IRA conversions on Page 2. Each spouse reports his or her backdoor Roth IRA conversion on separate forms 8606, so the tax return for a married couple who are both doing backdoor Roth IRAs should include two forms 8606.
Under a pro rata rule, Roth IRA conversions are taxed as if the money comes from all of the taxpayer’s IRAs. Suppose Sue Dawkins, age 74, has $30,000 of pre-tax money in traditional IRAs. Sue contributes $7,500 to a nondeductible traditional IRA in 2023 and converts $7,500 to a Roth IRA on Form 8606. Here, Sue starts with a total of $37,500 in her traditional IRAs so 20% of the conversion ($7,500/$37,500) will come from the after-tax side and 80% from the pretax side. Sue’s $7,500 Roth conversion will include $6,000 of taxable income (80% of $7,500), leaving her with $24,000 of pre-tax money in her traditional IRA and $6,000 of after-tax money.
QCDs from such a split IRA are considered to come first from pre-tax dollars, then from after-tax dollars. Thus, Sue can make a favorably taxed QCD up to $24,000, assuming she has made no deductible IRA contributions after age 70-1/2. If Sue empties her $30,000 traditional IRA with a direct contribution to a qualifying recipient or recipients, $24,000 would be treated as a QCD (no taxable income) and the other $6,000 would be taxable income, possibly offset by a charitable contribution tax deduction if Sue itemizes deductions on her tax return for the year.
Split the spouses. If a married couple is older than 70-1/2, this is a straightforward approach. One spouse can make tax-deductible contributions to a traditional IRA each year, up to the amount allowed by reported income on a joint return and status regarding employer plan participation. The other spouse, meanwhile, can make QCDs, up to $100,000 a year, tax-free (indexed starting in 2024).
Even if they file a joint return, traditional IRA deductions from one spouse won’t trigger an offset of QCDs by the other spouse. Another option is to create a split-interest entity.
Look back. Tax-deductible IRA contributions can be withdrawn up to October 15 of the year after the contribution. That gives the IRA owner time to review all the numbers and revoke an IRA contribution in order to preserve QCDs, especially those that serve as RMDs.
For these and other ideas, be sure to look at the overall outcome on the relevant federal income tax return. Virtually all seniors eligible for QCDs are on Medicare; passing up tax-reduction strategies may lead in some cases to greater income, higher taxes, and steeper premiums for Medicare Parts B and D.
Additional planning points
This IRA deduction-vs.-QCD dilemma is limited to people over age 70-1/2. Such individuals may be financially comfortable, working from a sense of fulfillment rather than financial necessity. Often this desire to remain productive is accompanied by plans to support favored causes via donations.
That said, what planning approaches might make sense? Making a deductible IRA contribution might be a good start, while there is still earned income. QCDs might be deferred until work has dwindled; charitable contributions could come from non-IRA sources while work continues, perhaps taken as an itemized tax deduction. If no end to earned income is in sight, it may be better to use QCDs, to satisfy RMDs, and use other retirement accounts such as Roth IRAs to avoid QCD shrinkage. Whenever QCDs are used, it’s vital to obtain a contemporaneous written acknowledgement from charitable recipients to support favorable tax treatment.
Walking through all the possible paths to follow, it becomes obvious why a tax review and analysis should be ongoing, into and through retirement. Excellent tools are available for comprehensive wealth management these days—at our firm, we have had success using Holistiplan. In addition, my association with Ed Slott's Master Elite IRA Advisor group has helped me educate myself on important topics such as the one described in this blog, so that I can better serve our firm’s clients.
By Christian Cordoba
CERTIFIED FINANCIAL PLANNER™
Founder, California Retirement Advisors
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