Tax Attic: Two tax advantageous ways to get money from an IRA

The tax preparation business is changing as the tax rules continue to be as complicated as ever. As the old saying goes, change is the one constant that is always there. In reality, people who can’t deal with change don’t last long in the tax business. Congress, like always, passes tax laws with a high level of frequency. It will be very interesting to see what changes President Trump is able to get through a friendly Congress; especially concerning health care. The Affordable Care Act is so thoroughly tied into the tax system that changes to the ACA will immediately affect the tax preparation system. All in all, it is not any easier to prepare a tax return today than it was 5 or 10 years ago even though we all do have better software and better research materials at our disposal. There are just more rules to deal with. Of course, that’s what makes this business interesting to me. All of us at Action Tax Service are ready for the 2017 tax season. It will be April 18 before we can blink!

Let’s continue with the discussion of two tax advantageous ways to get money from an Individual Retirement Account without having to pay a 10% penalty or, in one particular instance, even having to pay tax on the distribution. First, let’s explore the strategy of having funds distributed tax-free from an Individual Retirement Account via a Qualified Charitable Distribution or QCD. Second, distributions received through an arrangement called a 72(t) can be received penalty free even if the recipient taxpayer is under the age of 59 ½.

Qualified Charitable Distributions have been in existence for over 10 years now. It was on an intermittent basis, however, until the Protecting Americans from Tax Hikes (PATH) Act of 2015 made QCDs permanent. Here are the rules. A QCD allows a taxpayer age 70 ½ or older to transfer IRA dollars from an IRA to a qualifying charity on a tax-free basis. The charity must be a 501(c)(3) entity that qualifies to receive donations that would be deductible on the taxpayer’s Schedule A. Private foundations and donor-advised funds do not qualify to receive QCD transfers. The money must go directly from the IRA to the charity. The check or transfer cannot become under the control of the taxpayer or the QCD becomes non-qualifying. Only taxable IRA amounts qualify for the QCD strategy. That means funds held in SIMPLE accounts, SEP accounts, retirement accounts such as 401(k) and 403(b) accounts, Roth IRA accounts, and inherited IRA accounts do not qualify for the QCD process. Up to $100,000 per taxpayer per year qualifies for a QCD. The transfer has to take place no later than December 31 for the year in question, i.e. for the 2016 tax year, the distribution must take place by December 31, 2016.

Those are the basic do’s and don’ts of the QCD process. But why should a taxpayer use the QCD process? There are many reasons. 1. A QCD can be used to fulfill the taxpayer’s Required Minimum Distribution (RMD). The RMD must be withdrawn by December 31 of the year in question and included as income. If properly used, the QCD satisfies the RMD requirement but does not have to be included as income. 2. Many taxpayers age 70 ½ or older don’t itemize deductions and therefore get no tax benefit from making a charitable contribution to their church or their favorite charity. The QCD, in effect, allows the taxpayer a pre-tax deduction for the charitable contribution because the QCD is not shown on the tax return. 3. The RMD is included as income and therefore may have detrimental tax consequences to the taxpayer. The RMD may cause a taxpayer’s social security benefit to be taxable; may cause the taxpayer to pay higher Medicare insurance premiums; and may cause other deductions that are based on the adjusted gross income amount, such as the medical deduction on a Schedule A, to be lower. The QCD removes the RMD from this tax increasing equation. All in all, just about all taxpayers with an IRA and an RMD who are presently required to file a tax return could benefit from using Qualified Charitable Distribution process.

The second process to discuss today is using the Internal Revenue Code Section 72(t) procedure to begin receiving distributions from an IRA before the taxpayer turns age 59 ½. The long name associated with the 72(t) strategy is called “receiving IRA funds as a series of Substantially Equal Periodic Payments”. Taxpayers using this strategy use a formula taking into account their life expectancy and the current amount in their IRA growing by a conservative percentage over that same life-span. The formula establishes a dollar amount that the taxpayer is entitled to receive each year over his/her life expectancy. This is the 72(t) distribution amount that the taxpayer must take out of the IRA without changing for at least the next five years or until he/she reaches the age of 59 1/2, whichever is later. For example, a taxpayer, age 42, has $200,000 in an IRA and he wants to begin taking distributions using the 72(t) procedure. Normally distributions taken from the IRA would be subject to a 10% penalty because the taxpayer is under the age of 59 ½. However, the 72(t) eliminates the penalty. At the age of 42, the tables say the taxpayer has a life expectancy of 41.7 years. The financial custodian of the account will compute the amount that the taxpayer must withdraw. Let’s say that amount is $3,000 per year. He/she must agree to take $3,000 out each year until the age of 59 ½ is reached. At that time, the amount can be stopped or increased. Let’s change the taxpayer’s age to 56. The financial institution calculates the 72(t) amount. This amount must be withdrawn for at least 5 years or until the taxpayer turns 59 1/2, whichever is later. In this case, the taxpayer must withdraw the same amount until he reaches age 61. It’s important to note that the 72(t) amount cannot be adjusted without IRS approval. If it is changed without IRS approval, the entire amounts withdrawn from the beginning will be subject to the 10% penalty. That would be a bitter pill to swallow. In the right situation, the 72(t) procedure can be a good one. This is Jerry Coon signing off.

Jerry Coon is an Enrolled Agent.

He owns Action Tax Service on Northland Dr in Rockford.

Contact Jerry at