If you have established either a Traditional IRA or a Roth IRA as a part of your retirement plan, you should understand the tax advantages and consequences of distributions.
Unlike traditional IRAs which impose Required Minimum Distributions (RMDs) each year once you turn 72, Roth IRAs do not require distributions during your lifetime. Roth IRA contributions were made with already taxed funds. If you are 59 ½ years old and have had your Roth IRA for five years, any distribution is tax free and penalty free to the fund owner. If you have not had your Roth IRA for five years and/or have not yet reached 59 ½ there are also some special exceptions to the tax and penalties if distributions are used for medical, home purchase, or education expenses.
If you don’t need to use the money for expenses, you can leave your Roth account alone and let your contributions and earnings continue to grow. You can leave your Roth IRA to a beneficiary or multiple beneficiaries, tax-free. This makes the Roth IRA a fantastic wealth-transfer strategy, or alternative to life insurance for final expenses.
If you have a Traditional IRA, the funds contributed to the account were pre-tax monies and as such have never been taxed. Once you reach the age of 72 you are required to draw money from your tax-deferred account/s as a Required Minimum Distribution (RMD). The IRS has a table for RMDs which uses factors like your age, and the amount in your IRA account/s on December 31st of the previous year, to calculate the RMD. The eventual aim is to distribute all the funds before your death. You can take your RMD out of one account, or take bits from each one, so long as you withdraw the required minimum. AARP has an RMD calculator where you can see what is involved.
Money from an individual retirement account (IRA) can also be donated to charity as a qualified charitable donation (QCD). If you are 72 or older and you need to take the required minimum distributions (RMDs) from your traditional IRAs, you can avoid paying taxes on those distributions, and effectively lower your Adjusted Gross Income (AGI), by making your distribution directly to a qualified 501(c)(3) organization in lieu of your usual contributions throughout the year.
This tax break was made permanent in 2015. If you are 70 and ½ years old (the previous age for RMDs) you can voluntarily make distributions to a qualified charity to reduce your AGI. You may take your first RMD by December 31 in the year you reach age 72, or you can defer it until April 1 of the following year. You may take your RMD amount as one lump sum at any point during the year or as multiple withdrawals throughout the year, provided the total withdrawn by the end of the year is at least the required amount. You are always allowed to withdraw more than the RMD amount.
If you choose to donate through your Traditional IRA to a registered charity, you must report the transfer to the IRS. Your IRA trustee must use IRS form 1099-R to report the Qualified Charitable Donation (QCD) on an account owner’s annual tax return. The IRA trustee, also called a custodian, is the institution that administers your IRA.
The IRA owner should also keep records of the direct charitable donation date, the account from which the donation came, the amount that was given, and the charity that received the donation.
Distributions must be made directly to the charity, not to the owner or a beneficiary of the IRA. All distribution checks must be made payable to the charity, or they will be considered by the IRS as taxable distributions.
To validate the deduction, you will also need a receipt from the charity stating that the donor received no goods or services in exchange for the contribution. Otherwise, the amount of the donation is reduced by the value of any goods or services received in exchange, and that part of the donation will be taxable. Be aware that you cannot also claim the charitable donation as a tax deduction on your income taxes.
While there are other retirement accounts that also impose Required Minimum Distributions, the Traditional tax-deferred IRA is the only retirement account from which you can transfer up to $100,000 to charity tax-free each year.
As part of your estate planning, you can also list 501(c)3 organizations as full or partial beneficiaries to your IRAs, possibly saving your heirs income and/or estate tax.
As always, before taking action, you should consult with your tax-deferred account trustee, and financial or tax professional, for more information on these distributions to charities and other methods of reducing your retirement funds taxes.