Earlier this year, Congress passed and the President signed into law the Pension Protection Act of 2006. Among its many provisions affecting federal tax law, were those that greatly encouraged charitable giving through the use of individual retirement account or IRAs. In a nutshell, the new law allows US taxpayers who are age 70 _ or older to make distributions directly from their IRAs to their favorite charity and exclude the distribution from their taxable income. As one might expect, there are many rules a taxpayer must follow in order to take advantage of the new law. Notably, the change is effective only for two years, the 2006 tax year and the 2007 tax year. Therefore those charities and potential donors who would like to take advantage of this opportunity certainly should act quickly and consult with their tax advisors as soon as possible.
The new law solves a problem that many holders of significant funds in IRAs faced when determining whether to contribute assets to charity. Due to the increased popularity of IRAs, for many people, their IRAs represents one of their larger assets. One of the reasons that the growth of IRAs has increased so dramatically is the ability of an individual to contribute to it on a tax deductible basis. Furthermore, the growth of investments within an IRA is exempt from taxation until amounts are actually distributed to the IRA beneficiary. Upon distribution, assuming the individual has reached the appropriate age, distributions made from the IRA are subject only to tax at ordinary income tax rates. Because of the significance of an IRA in many portfolios, individuals often look to an IRA as a source for charitable giving. Under prior law, any distributions from the IRA were subject to tax, even if they were made directly from an IRA to a charity. This often left the individual unable to take complete advantage of the charitable contribution deduction since the amount includable in income was not sufficiently offset by the amount of any resulting charitable deduction.
The following example highlights the problem. Assume a taxpayer who has reached 70 _ has an IRA in the amount of $200,000. All of the funds within the IRA consist of pre-tax contributions and tax free growth on the funds contributed to the IRA. Any distribution from the IRA would be entirely subject to income tax at the highest marginal tax rate applicable to the taxpayer. If the taxpayer then contributed the IRA funds to a public charity, the taxpayer would be entitled to take a tax deduction if the taxpayer claimed itemized deductions on his or her personal income tax return. However, the tax law requires a phase down or gradual reduction of itemized deductions based on the level of a taxpayer's income. The result for higher income taxpayers was full taxation of the amount distributed from the IRA to charity and a significant limit of the amount deducted as charitable contribution. The same result occurred even if the distribution was directly made from an IRA to a charity. The new law eliminates this problem for certain taxpayers.
The eligibility requirements of the new law establish rules concerning the flow of funds from the IRA to the charity, the timing of the transaction and the age of the owner of the IRA. The distribution from the IRA must be a “qualified charitable distribution.” This means that the distribution must be made directly by the taxpayer’s IRA trustee to a qualified “charitable organization.” A “charitable organization” is a public charity under the tax law, not including private foundations and certain donor advised funds. The exclusion does not apply to distributions made from simplified employee pension plans (SEPS) or Simple IRAs. It is important to emphasize that a qualified charitable distribution must be made directly by the IRA trustee to the charitable organization. Therefore, the taxpayer may not receive the distribution and then roll it over to a charitable organization. In this event the distributions would be taxable to the IRA holder. Additionally to qualify for the exclusion the IRA owner must be at least age 70 _ of age on or after the date of which the distribution is made.
Using the example set forth above, if the same taxpayer who had reached 70 _, had an IRA totaling $200,000 and made a $100,000 distribution directly to a public charity from their IRA, the amount would be entirely excludable from his or her taxable income. Note that the IRA holder must request that his or her IRA trustee make the distribution directly to one or more public charities. In addition, the distribution from the IRA must otherwise be considered a charitable deduction and the taxpayer cannot receive anything of value from the charity in exchange for the IRA distribution.
The new rules interact well with the “minimum distribution” rules applicable to IRAs owned by people who have reached age 70 _. The new law provides that qualified charitable distributions directly to a public charity are taken into account to the same extent they would have been taken into account if they had made directly to the IRA holder. This means that the IRA holder who facilitates an IRA distribution to a qualified charity is considered to have received a distribution for that year equal to the amount distributed to charity. For individuals who are well off financially, this new exclusion allows them to meet the required minimum distribution rules without incurring a tax liability, at least up to $100,000 limit for the years 2006 and 2007.
The new charitable giving incentive is limited to a ceiling amount and must be made within a certain time frame set forth in the law. The Act only allows distributions to be excluded from gross income to the extent they do not exceed $100,000 in any tax year. This limit is based upon the total amount of a taxpayer's qualified charitable distributions in any year. There is no carry over provision under the Act. Therefore, if the distribution from a taxpayer's IRA to charity exceeds $100,000 in any tax year, the excess amount cannot be carried to the following year. The excess amount must be included in the taxpayers gross income for the year in which the excess distribution is made.
Individuals need to act fast as the new law will expire for tax years beginning after December 31, 2007.
Steven Burke serves as Chair of the Tax Department at the McLane Law Firm. He concentrates his practice in the business and corporate tax areas as well as estate planning. He can be reached at (603) 628-1454 or [email protected]. The McLane Law Firm is the largest full-service law firm in the State of New Hampshire, with offices in Concord, Manchester and Portsmouth.