Qualified Charitable Distributions (QCDs)

Why Don’t I Get a Charitable Deduction Anymore?

Some retirees have paid hundreds, sometimes thousands, of dollars unnecessarily to the IRS in the past year because they didn’t know the tax exclusion I am about to introduce to you. If you are over age 70.5, have an IRA, and donate to charities, you are likely overpaying taxes if you aren’t aware of the changes that occurred at the beginning of 2018 and how those changes impact your tax liability.

The information I’m sharing is not some type of untested or questionable item from the IRS code that the IRS has yet to rule on. Rather, the methodology I am about to describe has been around for years. The new tax law has only made the use of it more impactful. Now, there are large tax savings to be had or no tax savings at all when it comes to charitable giving. The tax savings depends not just on how much is donated to charity but how the donation to charity is done.

The Standard Deduction Problem

Stated as simplistically as possible, when we do our taxes, we add up our income then we subtract our deductions, and we all have deductions. We either itemize our deductions or, if we don’t have enough itemized deductions to add up to be more than the standard deduction, we automatically take the standard deduction. The standard deduction is an amount that all tax filers use to deduct against their income if their itemized deductions don’t add up to more than the standard deduction.

Prior to the tax law change, the standard deduction for a single person age sixty-five was $6,500 and for a married couple age sixty-five it was $13,000. The new tax law essentially doubled the standard deduction. Now the sixty-five-year-old single person has a standard deduction of $12,950 and a couple age sixty-five has a $25,900 standard deduction. Along with doubling the standard deduction, items that were once eligible to deduct have been taken away. To list a few, state and local taxes are now deductible only up to a maximum of $10,000 annually. Mortgage interest on certain types of home equity loans are no longer deductible. Miscellaneous deductions for professional services such as tax preparation fees and investment management fees are no longer deductible.

The bottom line, with larger standard deductions and fewer items that are eligible to be deducted, most of us will forgo itemizing our deductions and we will end up taking the standard deduction. Previously, about 30% of us itemized. It is now estimated that only 10% of Americans will itemize their deductions in the future.

So, how does this impact those that give to charity? Although gifts to qualified charities are still available as an itemized deduction, most charitable givers will not receive any tax benefit for their donations. Why? Because few will donate enough to charity and have enough other itemized tax deductions to exceed the standard deduction. Therefore, there will be no tax benefits for donating to charity for the 90% of Americans that don’t end up itemizing deductions. Fortunately, there is still a provision in the new tax law that can provide a huge tax relief to retirees who give to charity. A little bit of knowledge can save you thousands.

Tax-free Charitable Contributions through a Qualified Charitable Distribution (QCD)

A qualified charitable distribution (QCD) is a provision of the tax code that allows a withdrawal from an IRA to be tax free as long as that withdrawal is paid directly to a qualified charity.

Think about the tax advantages of doing a QCD:

  • You didn’t have to pay income tax when you earned the money you put into an IRA or 401K.
  • You didn’t pay taxes on the compound interest your IRA has earned over the years it has been accumulating in the IRA.
  • Any money paid directly to a charity using a QCD from your IRA will not be taxed.
  • And, QCDs qualify toward satisfying required minimum distribution (RMD) requirements.

The best way to understand the tax savings realized by the use of QCDs is by comparing a couple’s tax liability if they contribute to charity the traditional way, by writing a check to their charity, versus donating to their charity through the use of a QCD.

Example of QCD using a Standard Deduction

Since retiring, Michael and Megan’s income and expenses are fairly predictable. Their annual income consists of $35,000 in social security and $20,000 in pension income. Additionally, because they are over age 70.5, they are required to take $10,000 out of Michael’s IRA as a required minimum distribution (RMD). Therefore, their total gross income is $65,000. They make charitable contributions to their church and to other charities within their community of $7,000 annually.

Because their itemized deductions don’t add up to more than the standard deduction, they take the standard deduction. Notice, they will not get a tax benefit for making the $7,000 contribution to their charities. Their tax bill for the year is $1,637.

Alternatively, if Michael and Megan were to do a QCD and make a tax-free transfer of $7,000 directly to their charities, versus writing a check to their charities, their tax liability would be reduced by $1,612. This $1,612 tax savings resulted not in how much they donated to charity but how they donated to charity.

Table of taxes owed when making Charitable Donation paid by check compared to Charitable donation paid using a QCD and standard deduction

Before those of you that itemize your taxes become too comfortable and think QCDs are only for those that take the standard deduction, let’s do another example of Jim and Lisa, who plan to itemize their taxes.

Example of QCD using Itemized Deductions

Jim and Lisa’s annual income consists of $35,000 in Social Security, and $40,000 in pension income. Additionally, because they are over age 70.5, they are required to take $60,000 out of Jim’s IRA as a required minimum distribution (RMD). Therefore, their total gross income is $135,000. Contributions to their church and to other charities within their community amount to $25,000 annually.

The payment of $25,000 to charity and a $10,000 payment for state and local taxes are allowable itemized deductions. Because their $35,000 of itemized deductions are more than the standard deduction of $27,000, they plan to itemize. After itemizing, their tax bill ends up being $18,795.

Alternatively, if Jim and Lisa were to do a QCD and make a tax-free transfer of $25,000 directly to their charities versus writing a check to their charities, their tax liability would be reduced significantly. If they were to do a QCD, they would end up taking the standard deduction, but their tax liability would still be reduced by $5,303. Again, this $5,303 tax savings resulted not in how much they donated to charity but how they donated to charity.

 

Table of taxes owed when making Charitable Donation paid by check compared to Charitable donation paid using a QCD and itemized deductions

Restrictions and Reporting

As beneficial as QCDs are, they unfortunately are not available to all taxpayers and the rules governing these transactions must be followed with exactness or the QCD transaction will be considered a taxable IRA distribution.

Here are the restrictions:

  • QCDs are available only to people that are age 70.5 or older.
  • QCDs are allowed only from IRA accounts. Distributions from 401Ks and various other types of retirement accounts are not QCD eligible.
  • To qualify as a QCD, the distribution must be a direct transfer from the IRA to a qualified charity.
  • A maximum of $100,000 annually is allowed to be transferred to charity using a QCD.
  • You cannot make a qualified charitable contribution by transferring to a Donor Advised Fund.

One final note of great importance: the IRS and the investment industry have yet to figure how to code QCD so as to maintain the tax-free transfer. Until the IRS comes up with a code to delineate QCD distributions from normal taxable IRA distributions, QCD distributions will be coded as normal taxable distributions. However, the IRS has provided special instructions on how QCDs should be reported on our Form 1040s.

In running projections with our clients, we discovered that in almost every instance, those who give to charity and simultaneously make distributions from an IRA can benefit from doing a Qualified Charitable Donation. I believe that every person over age 70.5, who has an IRA, and who gives to charity should investigate making charitable contributions via QCDs. You or your tax professional can run tax comparisons by paying charitable contributions with cash versus doing a tax-free transfer from your IRA to your charity using an QCD. Many of you will find the tax savings to be significant.

ABOUT THE AUTHOR

Scott M. Peterson is the founder and principal investment advisor of Peterson Wealth Advisors. Scott has specialized in financial management for retirees for over 30 years. Scott is a regular presenter at BYU’s Education Week and speaks often at other seminars regarding financial decision making at retirement. He also literally wrote the book on retirement income, Plan on Living: The Retiree’s Guide to Lasting Income & Enduring Wealth.

If you are getting close to retirement and will have at least $1,000,000 saved at retirement, click here to request a complimentary copy of Scott’s new book!

How Tax Withholding Affects Your Tax Refund

Every year, around March and April, we begin to hear people talk about the big plans they have to spend their anticipated tax refund. Some plan vacations to various destinations around the world, others plan to pay off debt, or add to their savings. All too often, this anticipated windfall turns into an unwelcomed tax bill to the IRS.

We have found that many individuals may not know what goes into calculating their yearly income taxes and why they may or may not get a tax refund. This article will serve as a simple reminder of the fundamental components that determine your tax refund.

What are Tax Refunds?

Tax refunds are not gifts from the government that you receive for filing your taxes. They are a return of your dollars that you have overpaid in taxes during the year. In most cases, when you receive some form of taxable income whether it be from a pension, Social Security, or a distribution from a retirement account, a portion of your payment goes directly to the IRS, or toward paying your state income taxes. This is known as withholding. You, the taxpayer, controls how much of your payment goes towards paying the IRS and the state. Due to tax deductions, tax credits, or a miscalculation, a household may over or under withhold the required yearly income tax they owe. An over payment of taxes will result in a tax refund, and an under payment will result in owing a tax liability. So, you, not the IRS or your state government, decide whether you get a refund each year because you determine how much is withheld from each paycheck.

The amount of your tax refund or liability received at the end of the year is not a good indication of your total yearly income tax liability. For example, a large refund does not mean your taxes are low, and having to write a check to pay state and federal tax does not mean your taxes are high. Receiving a refund or paying a liability is a reconciling of the income tax dollars you are required to pay.

Tax Withholding

Tax withholding can be adjusted on income from Social Security, pensions, distributions from IRAs, and salaries. You can also make an estimated quarterly payment directly from your checking account. So, if a person is looking for a large tax refund, they should increase the amount of taxes that are withheld throughout the year and the IRS will return it to them in the form of a refund.

Does it Matter if I Over-withhold or Under-withhold?

In most cases, the goal is to withhold taxes in the amount that will result in as small of a refund, or tax liability as possible. However, incomes, salaries, and laws can all change throughout the year making it difficult to achieve the goal of a net zero tax refund or tax liability. So, is it better to overpay taxes during the year and get a refund? The answer… it depends. It comes down to preference. Individuals who prefer to receive a tax refund check during tax season should look to over-withhold. Individuals who prefer to have extra cash throughout the year, even if that means paying a tax bill come tax time may prefer to under-withhold.

There are two extremes that help explain the concept of withholding and tax refunds.

  • Under-withholding: A couple has a taxable income of $81,050 in 2022 and withholds nothing. Their paychecks will be higher throughout the year, but when they file their taxes, assuming no penalty applies, they will owe a federal tax bill of $9,315.
  • Over-withholding: A couple has the same taxable income of $81,050 in 2022 and withholds $14,315. Their paychecks throughout the year will be lower since a higher portion is going to tax withholding. Instead of owing $9,315 at the end of the year, they will receive a refund of $5,000 because they over withheld.

It is important to understand that, assuming no under-withholding penalty applies, over or under-withholding taxes throughout the year does not result in a larger or smaller total tax liability. The only difference is the timing of when the taxes are paid.

When do Underpayment Penalties Apply?

You may be thinking, “Well if the timing of my tax payments doesn’t impact the amount of total tax I pay, then I won’t withhold anything all year and invest the tax payments in a high yield investment account. I can then pay my full tax bill at the end of the year and keep the interest I earn.” This can be a reasonable strategy assuming two things. First, you don’t lose money in your investment over the course of the year, and second, you don’t pay more in underpayment penalties than you make in interest. In most cases, you can avoid an under-withholding penalty if you withhold at least 90% of the tax due for the current year, or if you withhold 100% of the previous year’s tax liability.

You Owe What You Owe

Whether you are looking for a tax refund, or you prefer to not give the government an interest free loan and plan on paying your tax liability every April, you can rest assured knowing that as long as you satisfy the minimum withholding requirements, your total tax obligation will be the same.

The SECURE ACT: Tax Law Changes for IRA’s that Impact Retirees

As 2019 came to a close, the president signed into law a sweeping series of changes that will affect how we save for retirement as well as the distribution of IRA proceeds. The new law is officially entitled the Setting Every Community Up for Retirement Enhancement Act, but it is more commonly known as the SECURE Act. This new law includes both welcome changes as well as some controversial elements. As I said, the changes brought about by the SECURE Act were sweeping, but I am only going to highlight those changes that impact the retiree.

First, let’s address the more controversial parts of the law. There is a change to the rules that govern inherited IRAs, or so-called stretch IRAs.

Stretch IRAs

Previously, if you inherited an IRA, you were allowed to take distributions from the retirement account over your life expectancy. That is to say, a healthy 40-year-old person who inherited an IRA from their parents or grandparents could withdraw the funds over several decades.

While there are exceptions for spouses, minor children (until they reach the age of majority), disabled individuals, the chronically ill, and those within 10 years of age of the decedent, the new law requires that you withdraw the assets from an inherited IRA account within 10 years if the decedent passed away after December 31, 2019. There are no changes to inherited IRA accounts for those who died prior to 2020.

In the past, we have commonly recommended that an IRA participant’s spouse be listed as the primary beneficiary and the children be listed as secondary beneficiaries (not the family trust). This, most likely, may still be your best option, but the new law makes listing the children individually as beneficiaries less tax advantageous than before the new tax law went into effect. We look forward to discussing alternatives with you to make sure your family has the right beneficiary designation going forward.

Long Overdue Changes:

While the law governing stretch IRAs is creating challenges, there are also big, positive changes that we believe are long overdue.

  1. If you turned 70½ after January 1, 2020, the initial required minimum distribution (RMD) for a traditional IRA is being raised from 70½ to 72. Those who turned 70½ prior to January 1, 2020, are still required to take RMDs based on the old rules.
  2. You may now contribute to a traditional IRA past the age of 70½, if you are working and have earned income. Previously you were unable to make IRA contributions past age 70½.
  3. Many of you donate to charity directly from an IRA by making a Qualified Charitable Contribution (QCD). Now, even though some of you will not have RMDs until age 72, you are still able to donate to your charities using a QCD starting at age 70½.

Hopefully, this sheds some light on the parts of the SECURE Act that most likely apply to your situation. We appreciate the trust you have placed in us and we look forward to answering any additional questions that you might have.

Peterson Wealth Advisors has taken the academically brilliant idea of time segmentation and transformed it into a practical model of investment management that we call “The Perennial Income Model™”. To get a better understanding of the Perennial Income Model™ you can request our book “Plan on Living, a Retirees Guide to Lasting Income and Enduring Wealth”. For specifics on how the Perennial income Model™ could be applied to your retirement income plan, schedule a complimentary consultation with one of our Certified Financial Planner™ professionals

Scott M. Peterson is the founder and principal investment advisor of Peterson Wealth Advisors. Scott has specialized in financial management for retirees for over 30 years. Scott is a regular presenter at BYU’s Education Week and speaks often at other seminars regarding financial decision making at retirement. He also literally wrote the book on retirement income, Plan on Living: The Retiree’s Guide to Lasting Income & Enduring Wealth. 

How the CARES Act Impacts Retirees

We are all on information overload these days, so I am trying to only share information with you that is pertinent and that directly impacts your situation as a retiree.

Our government sprang into action this past week to create an unprecedented stimulus package to combat the financial effects of the coronavirus. The new law resulting from this stimulus is called the Coronavirus Aid, Relief, & Economic Security Act or the CARES Act. The CARES Act covers a lot and it contains provisions that are designed to benefit individuals as well as businesses. I think it is important for you to understand some of the major provisions of this new law but the following is not intended to be an all-encompassing review of the CARES Act. I simply want to outline those provisions of the stimulus package that most impact retirees.

  1. Eligible taxpayers will receive a tax rebate check. The amount of the tax rebate is $1,200 per person plus $500 per dependent child. The amount of the check is reduced by a phaseout provision for individuals who made over $75,000 and couples that made over $150,000 last year, or in 2018 if you have not filed your 2019 taxes. Starting in May, you should begin to see this money deposited in the checking account that receives your tax refund or into the account where your Social Security check is deposited. If the government has no checking account on file for you, you will receive a check in the mail. Please be careful of scams! Nobody from the government will be calling or emailing you regarding this rebate!
  2. Many retirees begrudgingly take money that they don’t need out of their IRAs once they are age 72 (previously was age 70.5) because the required minimum distribution rules stipulate that they such a distribution. The CARES Act has eliminated the IRA required minimum distribution requirements in 2020. Retirees who have taken required minimum distributions within the last sixty days can redeposit their RMD to eliminate the tax on those distributions. For retirees who donate to charity: It can still be advantageous to make charitable contributions directly from your IRA to your charity even though there is not a required minimum distribution obligation in 2020.
  3. The tax filing deadline has been extended from April 15th to July 15th. This means that the date to make 2019 contributions to IRA and HSA accounts has also been extended to July 15th.

There are additional provisions and benefits associated with the CARES Act for those that have contracted the virus, have a spouse that has contracted the virus, or if you have lost your job as a result of the coronavirus. I won’t mention those benefits here but you should be aware that they exist if you are unfortunate enough to fall into this category.

Please contact us if you would like specifics or have any questions.

 

3 strategies to deal with you RSU tax bomb

An old friend of mine works for a technology company in Utah. The company was recently acquired, and he will receive $1,000,000 from the company’s Restricted Stock Unit Plan. He is already in a high tax bracket from his regular income and his RSU payout will only compound his tax problems. He stands to lose between 40-45% of his RSU payment to taxes!

So how does one deal with the RSU payment tax bomb?

A little bit of proactive tax planning can go a long way to help you keep more of your RSU benefit now and help you secure your future.

3 strategies for reducing the tax hit from your RSU payment:

1. Max out your 401k contributions. This idea is simple, so simple in fact that many people will probably overlook it. For 2019 you can contribute $19,000 on a pre-tax basis, and an extra $6,000 on top of that if you are over age 50. If you are not on track to max out your 401k, talk with your HR department to make the switch. In the year you receive your RSU payment, you will want to make sure that your 401k contributions are happening on a pre-tax basis. Roth 401k contributions may have made sense in past years, but it will not be your best option in the year of an RSU payment.

2. Fund a 529 education account for each of your children. Utah offers a 5% tax credit for contributions up to $4,000 per qualified beneficiary. This means you can get a $200 tax credit for each child. With a 529 account, you are not only reducing your taxes this year, but all the growth is also tax free and will be tax free when it is taken out to pay for college down the road.

3. Pre-pay multiple years of charitable donations. This is the most powerful tax reduction strategy available through the use of a Donor Advised Fund. A donor advised fund, or DAF for short, is like a charitable investment account that holds your charitable dollars until you ultimately decide where you want those charitable dollars to go. The value of the DAF is that you will receive a tax deduction in the year when you need it most and the money you donate to the DAF can then be parsed out in future years to pay church donations or to support other charitable causes in the community. The funds can even be used to pay for the missions of your children and even grandchildren! Another unique benefit of a donor advised fund is that the money that is placed in the fund can be invested. This means your initial contribution to the DAF can potentially grow to enhance the future value of your contribution to your charities.

One last piece of advice: buying a product is not the solution, having a plan is. There are plenty of salesman who are eager to earn a commission by selling you a product, but what you really need is a plan. At Peterson Wealth Advisors we have been helping successful professionals and retirees with complex financial planning decisions since 1986. Click here to learn more and schedule a complimentary consultation to review your situation with one of our experienced advisors!

Best Tax-Friendly Places to Live for Retirees

If you’re approaching retirement age, you may be considering a move to a more retirement-friendly state, particularly if your current state of residence imposes numerous taxes on social security, pensions, and other retirement income. While making the decision to relocate is not something that can be done lightly, there are a variety of options available nationwide that may allow you to retain more of your retirement income.

Of course, taxes alone are not the only reason to relocate; climate, proximity to health care, cost of housing, and property taxes all need to be taken into consideration.

States that offer a tax-friendly environment to retirees:

Alaska – While it may not be the first choice of retirees, Alaska offers an excellent environment for retirees with neither Social Security nor pensions taxed. Another advantage is the lack of state income tax and sales tax.

New Hampshire – Retirees residing in New Hampshire are exempt from state taxes on Social Security and pay no taxes at all on pensions or distributions from their retirement plans. As an added bonus, there is no state sales tax either. Homeowners, however, need to take into account that property taxes are higher than most other states.

Nevada – There’s a reason why so many retirees gravitate to Nevada, and it isn’t for the slot machines. Nevada has no state income tax, so Social Security and other retirement income are tax-free. There is a sales tax in Nevada, though food and prescription drugs are currently exempt. Property taxes are reasonable, however, there are no breaks given to those over the age of 65.

Florida – Florida remains popular with retirees for a lot of very good reasons. With no state income tax, residents are able to retain more of their Social Security and retirement income. One downside is the state’s sales tax rates that can go upwards of 7% in some areas. However, property taxes are slightly below the national average, with some counties offering homestead exemptions to homeowners over 65.

Wyoming – While Wyoming may not be on anyone’s radar when it comes to retirement, the state offers a lot of benefits to retirees, including no state income tax. Sales taxes are also relatively low in Wyoming, and property taxes are minimal.

Mississippi – Social Security and other retirement income, including retirement plan withdrawals, and public and private pensions are exempt from state income tax in Mississippi. The state sales tax rate is high at 7%, and the state also imposes sales tax on groceries though other items such as prescription drugs and utilities are exempt. Property taxes are also some of the lowest in the U.S.

Other states with no state income tax include Texas, Washington, South Dakota, and Tennessee. While a lot of factors need to be taken into consideration when looking to relocate, these states make it just a little easier on your wallet, so you can enjoy your retirement stress-free.

Resources

https://www.kiplinger.com/slideshow/retirement/T006-S001-most-friendly-states-for-retirees-taxes/index.html