Business column: Don’t need your required IRA distribution this year? Consider donating to charity

Brian Littlejohn

It’s that time of year again. Temperatures are falling, days are getting shorter, and the holidays are just around the corner. And if you’re 72 or older or recently inherited a traditional IRA, it may be your last chance to take required minimum distributions (RMDs). But what if you don’t need the money? To avoid paying taxes on income you don’t need this year, consider donating your RMD to charity.

What is a Required Minimum Distribution?

A required minimum distribution, or RMD, is the amount of money you must withdraw from an employer-sponsored retirement plan, traditional IRA, SEP or SIMPLE individual retirement account (IRA). The purpose of RMDs is to prevent individuals from using certain types of retirement accounts to avoid paying taxes.

Prior to 2020, account owners had to begin taking RMDs at age 70-½. However, in 2020, the age changed to 72 as part of the SECURE Act.

In addition, the SECURE Act of 2019 changed the rules for inherited IRAs so that certain heirs may have less time (10 years maximum) to remove the funds from the IRA. This primarily applies to nonspouse beneficiaries who inherit an IRA from someone who passed away in 2020 or later. Spousal beneficiaries and certain eligible nonspouse beneficiaries may be allowed to take RMDs over their life expectancy.

How are RMDs taxed?

In most cases, RMDs are treated as ordinary income for tax purposes. However, you don’t have to pay taxes on your basis (any amount you already paid taxes on).

What happens if you miss an RMD?

While there are some exceptions, failing to take an RMD typically results in a harsh penalty from the IRS. Indeed, Uncle Sam collects 50% of the shortfall plus taxes. So, if your RMD is $40,000 and you withdraw only $20,000, for example, you’d owe a $10,000 penalty plus income tax on the $20,000 shortfall.

If you miss an RMD, you can ask the IRS for relief by filing Form 5329 with a letter of explanation. However, there are safeguards you can put in place to avoid forgetting — for example, hiring a fiduciary financial advisor to help keep you on track.

Donating RMDs to charity

Depending on the size of your withdrawal and your other sources of taxable income, RMDs can potentially push you into a higher tax bracket. Or they can increase your tax bill in a year when your taxable income is already higher-than-normal. Fortunately, there are strategies you can use to avoid these potential tax consequences.

For example, if you don’t need the income, one option is to donate your RMD to charity. A qualified charitable distribution, or QCD, allows IRA owners to transfer up to $100,000 directly to charity each year.

A QCD can satisfy all or part of your RMD, depending on your income needs. (You can also donate more than your RMD, so long as you stay below the $100,000 threshold.) QCDs are nontaxable and don’t increase your adjusted gross income (AGI) as an RMD would. A lower AGI may also expand your eligibility for certain tax credits that you otherwise wouldn’t qualify for.

It’s important to note that the IRS considers the first dollars out of an IRA to be your RMD until you meet the full requirement. In other words, if you decide to do a QCD to reduce your tax liability, be sure to make the QCD before making any other withdrawals from your account.

Planning is key when it comes to RMDs

Required distributions can significantly impact your tax situation if you don’t have a strategy for taking them. Whether you’re in retirement or you’ve recently inherited an IRA, it’s important to plan your withdrawals accordingly to avoid any unnecessary tax consequences.

Remember, a QCD is just one option for managing RMDs. There may be other strategies that make more sense for you and your family. To find out for sure, consider working with a fiduciary financial advisor, who can assist you in developing a withdrawal strategy that helps you achieve your financial objectives while minimizing your annual tax bill.

Brian Littlejohn, CFP®, CFA is a fiduciary financial advisor at Sherwood Wealth Management in Glenwood Springs. He enjoys helping his clients gain greater control over their finances.

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