What are Qualified Charitable Distributions?
I get a lot of questions from my family, friends and clients about money. One of the most common questions I get from my people nearing or in retirement is this:
“Once I’m 72, do I really have to take money out of my retirement accounts every year for the rest of my life whether I need the money or not?”
Yes. You do.
In fact, one of the things the big 401k providers forgot to help us better understand when we signed up for our retirement accounts in our 20’s and 30’s, is the tax impact that these annual required withdrawals, officially known as Required Minimum Distributions (or RMDs), can have on our retirement savings and income.
If the best time to understand those tax consequences was in our 20’s or 30’s the next best time is right now!
I’m going to let you in on a little secret.
The primary goal of our federal and state taxing agencies, as it relates to our tax deferred retirement savings, is to have us completely deplete these accounts before our big graduation day when we meet our maker.
It’s an “investment” our government makes in our retirement savings.
In a nutshell, here’s how that investment works. We invest our first dollar into our tax deferred retirement savings account. We receive a small tax break on that dollar that may save us about 20 or 30 cents on that dollar. That 20 or 30 cents “invested” by our taxing agencies now gets to experience the 8th wonder of the world; the magic of compound interest.
That $1 saved in our 20’s can grow to much as $32 or more by the time we are in our 70’s. It is at this point in our lives that our government taxing agencies get to realize an enormous return on that little 20-30 cent investment. Now they get to collect ordinary income taxes on that much larger amount of money, sometimes more than 50% of the value. And the best part is, we are required by law to withdraw this money, each and every year from the age of 72 on, and pay the ordinary income taxes owed on those withdrawals (RMDs).
A 20-30 cent investment that becomes $16 (50% tax on $32) is one heck of a long-term return on that investment.
Let’s do some more easy math to fully understand these tax implications, which is a simpler way to describe the governments return on their investment versus our return on our investment.
Imagine at 42 years old, you have accumulated $500,000 in your retirement plan. Using some middle school math, we can calculate the future value (specifically how long it will take for our money to double in value) by dividing 72 by our assumed rate of return on our investments. Assuming we do not save another dollar from this point forward, and we earn an average rate of 7% per year, we know our money will double every 10.2 years (72 divided by 7 = 10.2).
That means at ten years later at 52 years old my account could be worth $1 million, $2 million at age 62, and $4 million at age 72.
This is a mathematical certainty IF, and it’s a big IF, you earn an average rate of return of 7%. If you earn less than that, say 6% (divided into 72) it will now take you 12 years to double your money. But for the purposes of this example, lets stick with our 7% assumed average rate of return.
Assuming you do not earn another dollar on your retirement savings, you could pay as much as $2 million or more in ordinary income taxes on that $4 million retirement savings account over the remainder of your life, leaving you with half or less than half of what you actually saved and earned for you, your heirs, and the causes you are most passionate about.
Let’s go back to that first dollar again. You invested a dollar to one day receive half of $32. The government invested 20-30 cents (in the form of a tax deduction to you) to also receive half of $32.
Who received a better return on their investment? Does that seem right to you?
The good news is you do have options of how to use that required minimum distribution (RMD) every year. If you are mindful and intentional with what you do with your RMD, you could actually lower your annual tax bill, especially if you do not need the RMD to support your lifestyle in retirement.
One of my favorite options is a financial tool called a qualified charitable distribution (QCD).
I am a huge believer in being very mindful and intentional with my money. I wasn’t always that way, but I am now. And I really encourage others to be the same way.
In our financial planning process; what we call the Wealth F.O.R.M.ation Experiencesm, I get to help the private clients of my firm, as well as the listeners of our Financial Sobriety Podcast, learn how to become super intentional and mindful with their money.
A key component of our planning experience is something we call the Clarity Compass. The Clarity Compass is an exercise that helps our clients and podcast listeners to get crystal clear on the people, places, and experiences that mean the most to them. Then we help them connect the dots on how to align their financial resources with those people, places, and experiences that mean the most to them.
This part of the planning experience often flushes out some causes and passions that really drive them – usually causes that are much bigger than themselves. Aligning a portion of their money to support that cause or passion becomes a very important priority in life once it is identified.
That’s where a tool like a qualified charitable distribution (QCD) can become very helpful.
By making a direct tax-free contribution using a QCD to a cause you are passionate about directly from your retirement account, your donation will reduce the amount you are required to withdraw and pay taxes on.
Let’s go back to our example from before an assume we now have a $4 million retirement account at age 72.
Your required minimum distribution (RMD) would be approximately $160,000. And that amount will go up each year as a percentage of your total IRA balance. Your RMD is based on your life expectancy. Each year you live, your life expectancy decreases, therefore the factor that calculates your RMD percentage must increase for our taxing agencies to achieve their ultimate goal – a zero balance on your retirement account that coincides with the date of your death.
If at this point in your life you have enough income coming to you through other sources, like pensions, rental income, passive business income, and/or social security, adding your $160,000 RMD to your adjusted gross income on your tax return forces you to pay more taxes on money you don’t need, and potentially thrusts you upward into a much higher tax bracket that could increase your overall tax liability on a greater portion of your adjusted gross income.
If you were to make an $80,000 QCD in the same year, you would only be required to withdraw an additional $80,000 taxable distribution from your retirement accounts to satisfy your RMD, reducing your taxable income by $80,000. That potentially keeps you from reaching that higher tax bracket. It also saves you tax on the additional $80,000 you would have been required to withdraw had you not made the QCD.
QCDs are fairly simple transactions to make. And it’s definitely something your financial advisor and your tax advisor can team up together to help you with.
Become super intentional and mindful with your money.
Support causes you are incredibly passionate about.
Ensure that the retirement savings you worked for your entire life is in alignment with the values and causes you’re most passionate about.
Do not leave those decisions to some large faceless government bureaucracy that may not always be in alignment with the values and causes you are most passionate about.
Are you with me? Call your financial and tax advisory team today to make sure your retirement dollars are aligned with what matters most to you.