2020 Tax Planning Dilemma: Still Use the QCD?

With the suspension of required minimum distributions (RMDs) in 2020 by way of the CARES Act, there’s a question that all individuals over age 70.5 need to be asking this year: Is it still more tax efficient to make charitable gifts from my IRA via qualified charitable distributions (QCD) even though there is no RMD to reduce or avoid?

As a quick refresher, the QCD (explained more fully in this Golden Bell article) was first authorized by Congress in 2006. It lapsed and was reinstated five times over the coming years only to become permanent in 2015. Regrettably, consumers barely took notice of this useful tax strategy until the Tax Cuts and Jobs Act which dramatically changed the tax law starting on January 1, 2018. Despite its lack of use and appreciation, the QCD is not a complex tax planning strategy that only applies to a small fraction of taxpayers. It permits any taxpayer over age 70.5 to make IRA distributions directly to a public charity without treating the distributions as taxable income¹. Save for taxpayers over age 70.5 who retain a large primary residence mortgage into their 70’s or those with unusually large medical expenses, nearly all taxpayers with a Traditional IRA will reduce their overall tax liability by fulfilling charitable gifts via the QCD rather than by other methods such as giving cash or appreciated securities.

The QCD calculus changes in 2020 because of the RMD suspension enacted by the CARES Act. In normal years, when taxpayers have a required minimum distribution and fulfill some or all of their RMD by use of the qualified charitable distribution, they reduce adjusted gross income dollar-for-dollar by the amount of the QCD. Although there are a few scenarios where this may not be advantageous in the long term², reducing adjusted gross income generally results in a reduction in taxes which makes the QCD advantageous for most taxpayers over age 70.5.

Making charitable contributions via the QCD in 2020 does not reduce 2020 taxes because there is no RMD that the QCD is replacing.³ However, fulfilling charitable donations in 2020 by using the QCD in lieu of giving cash or securities still has a favorable impact on future taxes because the taxpayer reduces IRA assets which inherently have a deferred tax liability. A taxpayer who faces a 22% marginal tax rate, for example, and donates $100,000 from his IRA via the QCD, has just eliminated $22,000 of future tax liability (for him, or for his beneficiaries, assuming the same 22% tax rate applies).

To evaluate the tax impact of the QCD in 2020, we can compare the value of this reduction in future taxes via the QCD to the alternative of donating cash or appreciated investments which may have present and/or future tax benefit. Let’s start with the following baseline scenario: Jill is age 75 and has $1 million of IRA assets and $1 million of after-tax assets. She gifts $10,000 per year to charity and requires another $70,000 per year in after-tax dollars from her financial assets for living expenses. Jill’s 2020 dilemma is whether she donates the $10,000 to charity from her IRA via the qualified charitable distribution or whether she gives the gift from cash or appreciated assets.⁴

QCD vs. Cash Donation

In the case where Jill is contemplating a gift of cash to charities in 2020 and will claim the standard deduction on her tax return, using the QCD is a decided no-brainer. By using the QCD instead of cash gifts, she will have an additional $3,745 of after-tax wealth at age 90 just for having donated the $10,000 from her IRA rather than from non-IRA assets. To the extent that she has beneficiaries who inherit her IRA at age 90 and who will be taxed on the distributions at a higher rate than her (32% vs. 22%), the benefit of using the QCD in 2020 is even greater – a $4,598 increase in cumulative after-tax wealth.

Let’s now change the scenario to assume that Jill gets some benefit from donating cash in 2020. Specifically, we can assume that Jill would take the standard deduction if she uses the QCD but if she makes a cash gift, she is able to deduct 50% of the value of the donation (the first $5,000 of the donation gets her to the standard deduction amount and the next $5,000 increases her itemized deductions). Even under this scenario, Jill comes out ahead in the long-run by using the QCD. She saves $1,100 on her 2020 tax liability (22% tax rate x $10,000 gift x 50% of gift increasing itemized deductions) by making cash gifts but foregoing the QCD results in higher future taxes. Despite the $1,100 advantage in year one, her total wealth is still $1,627 lower at age 90 by giving cash rather than utilizing the QCD.

The table below shows that only in the scenario where Jill is able to deduct every penny of her charitable gift (likely because of high mortgage interest expense) and where her beneficiaries are in the same tax bracket or a lower tax bracket when they inherit her IRA, is she better off giving cash rather than using the QCD.

QCD vs. Donating Appreciated Investments

A better solution to donating cash is using appreciated investments for charitable donations⁵. Donating appreciated assets qualifies for the same deduction as a cash gift⁶ and results in the avoidance of future capital gains taxes when the assets would have otherwise been sold. While making charitable donations in 2020 with appreciated investments is better than donating cash, it is still suboptimal to utilizing the QCD for all scenarios in our example except when the taxpayer gets the full gift value benefit of an itemized deduction. We evaluated Jill’s situation using different levels of pre-existing investment appreciation and show the results below.

Summary

One important thing to note here is that we have evaluated a few very specific situations and, as with nearly all financial planning decisions, the individual circumstances matter to the calculation. There are a number of variables that could impact the economics including whether the individual desires to leave assets to charity at death, the expected rate of return on investments, the age of the individual, the expected spend rate of the individual, and how quickly or slowly the ultimate beneficiaries will distribute any inherited IRA assets. That said, in working through the economics of this decision using many different variables, there is one consistent conclusion: using the QCD for charitable gifts in 2020 is almost advantageous except in situations where the taxpayer can fully deduct or near-fully deduct the value of the donation.

Endnotes

1. Notably, age 70.5 still applies for QCD eligibility even though the CARES Act changed the RMD age to 72.
2. Specifically, when the taxpayer is donating highly appreciated investments to charity in lieu of the QCD, would otherwise plan to sell such investments during his/her life, and has enough mortgage interest or medical expenses to fully deduct all charitable contributions.
3. Unless a taxpayer distributes funds from his/her IRA to make a charitable gift without using the QCD which would clearly be a mistake.
4. For purposes of this example, Jill faces a 22% marginal income tax rate and a capital gains rate of 15%. Her investments earn a 5% annual return with no taxable interest or dividends on assets outside the IRA. The $70,000 of core spending is raised at the beginning of each year and there is no inflation adjustment on these dollars or the $10,000 gift. After 2020, she fulfills the $10,000 annual charitable gift via QCD which reduces her RMD. Further assume that she lives another 15 years and that her IRA assets are distributed to heirs following her death at the same 22% tax rate.
5. Assuming the investments have been held for at least 366 days
6. With the caveat that the deduction from appreciated asset gifts is more limited as a percentage of AGI and, under some circumstances, may have to be spread over more than one year