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Retirees who have saved diligently, specifically into pre-tax retirement accounts, may find themselves in a position that can feel a bit awkward.
In their prime working years, as they’ve been saving into plans such as a 401(k) or 403(b), assuming they’ve been properly allocated through the ups and downs of market returns, it is likely they have noticed their accounts have generated a large balance of retirement assets.
In the event their income is sufficient without having to tap into these accounts, it can create a sense of security knowing that there is a nest egg that remains in the event they’ll need it or can be passed down to their kids.
However, there is one potential problem that could be facing these retirees. That problem comes in the form of taxes.
The Incoming Tax Problem
As retirees reach the magical age of 73 (or, depending on dates of birth, it could be a couple years before or after this age), their Required Minimum Distributions are set to begin.
While this may seem harmless, as you know this nest egg will begin to be tapped into eventually, it can also create an unforeseen problem for these retirees.
Depending on the size of the pre-tax account(s), the Required Minimum Distribution may generate income that isn’t needed. But this income will add to ordinary income, and can create higher income taxes, while also generating phantom taxes for retirees.
The higher the RMD(s), the larger the potential problem.
While we’ve touched on potential solutions previously, one we haven’t covered in detail is a planning topic that can benefit those who are charitably inclined.
A Tax Problem Meets a Giving Solution
We worked with a couple who had their husband start his encore career recently. This encore career created more income than they knew what to do with, which created a sense of intermediate security – their Social Security and his income are plenty sufficient.
But what about their RMDs? His RMD was required at Age 72, but he readily admitted he didn’t need (or want) any additional taxable income.
They’ve used the standard deduction thanks to the increased standard deduction of The Tax Cuts and Jobs Act of 2017. But how could they work around the increased income?
With a little prodding, we found out they have been charitably inclined to both their son’s non-profit work, but also a local 501(c)(3) organization they are both very active in.
The solution? A Qualified Charitable Distribution (QCD).
Why a QCD Makes Sense
Since the clients had been contributing to the qualifying charities with after-tax dollars, they were not getting any tax benefits in the year in which they had made these donations.
While they weren’t making the contributions for tax-saving purposes, hearing that they could keep those savings but still donate created a win-win for them and the 2 charities.
The RMDs would’ve put them into a higher tax bracket (from 12% to the 22% bracket), and as the RMD continues to grow, could eventually have increased their IRMAA surcharges on their Medicare Part B & D Premiums.
While these clients wouldn’t have experienced an increase on the taxability of their Social Security income, it could be the case for others.
It did, however, save them from being pushed into the 15% tax bracket for long-term capital gains. While it wasn’t a large amount of capital gains they realized, it was a tax savings nonetheless.
This tax strategy saved the couple over $12,000 in federal income tax.
While we don’t cover state income tax, this could have a trickle down effect as well.
Making It Work
Part of the reason this strategy worked the way it did was because the couple had already been donating to charity.
While they would have continued doing so, they were now able to save on taxes while continuing their giving intentions.
But this plan does need to follow a process.
First, the charitable organizations need to be classified as a 501(c)(3) organization. This information is crucial to make sure the QCD is properly executed.
From there, they needed to make sure their custodian allowed this. They had used Fidelity as their custodian, so making sure they had the necessary paperwork completed and the calendar deadline met was a necessity.
While they could’ve used a portion of their gift, they decided to use the whole $55,000 RMD as a QCD. However, if they wanted to gift $20,000, they could’ve done so, the remaining $35,000 would’ve counted as taxable income.
As mentioned earlier, they are using the standard deduction, so this plan made more sense being that they would not be itemizing their charitable donations.
Last, they also needed to properly request the distribution be sent directly to the charity. They couldn’t deposit the funds then gift afterwards.
Despite all that, there are 3 other items you should know if you’re looking to do this.
3 Things You Need to Know Before Doing This
The maximum allowable amount to do a QCD is $100k per spouse, per year. Had a single individual looked to do this, it would only be a $100k annual maximum. Since their RMDs were well below this, they could accomplish this first one with no problems.
The minimum age for a QCD is also 70.5 per retiree. Being that these retirees are in their upper 70’s, this was again not a concern. But for those out there considering it who are under 70.5, be sure your timing is properly accounted for.
Last, and this is an important one – the accountant needs to be notified, because the tax form that is generated the following January (1099-R) doesn’t show a QCD. Instead, we as the planners communicated with the CPA what was occurring, and the clients kept the evidence received in the event an audit would ever take place.
The Results: More Than Just Tax Savings
Of all the planning we do, our team finds this one to be the most rewarding. Yes, we love tax savings (and so did our clients). But to know that this was a gift that was felt for the clients, the charity, and the fact they have an option to continue doing so moving forward made this strategy impactful.
We recognize our clients don’t contribute to charities for the tax savings, as that goes against the spirit of the move. However, the IRS incentivizes taxpayers to contribute to charities, and the QCD is a powerful way in which you can do so.
A Strategy Worth Sharing
Taxes can be the largest expense for retirees over the course of their lifetimes. Focusing on smart tax strategies can accomplish the dual purpose of keeping more of what you earn, and keeping control of how your hard-earned dollars are shared.
This strategy should be considered if you have an RMD you may not need, and you’re already charitably inclined. If you’re looking for more ways to save on taxes in retirement, be sure to check out the post we did on Roth Conversions, as a way to minimize how much you’ll owe in retirement.