Saving taxes while donating your IRA:
The Pension Protection Act decoded

By Andrew Wolfe and Simone Berthoumieux, Cohn Wealth Management LLC

 

For over 30 years, Individual Retirement Accounts (“IRAs”) have been an effective personal savings plan, providing income tax advantages to individuals saving money for retirement.

 

You contribute money to an IRA[1] and it is invested. Earnings on the investments — interest, dividends and capital gains — accumulate tax-free until the money is withdrawn. The income, compounding tax-free over several years, results in increased retirement savings.

 

Individuals who have consulted with their financial advisor and determined that their retirement savings are more than they will need for retirement, may generously consider transferring assets from their IRA to a chosen charity.

 

As a general rule, if you transfer assets during your lifetime from an IRA to a charity, the transaction is treated as a withdrawal from your IRA and a subsequent donation to charity. The amount contributed to charity is included on your income tax return as ordinary income and offset by a charitable deduction. You may not be entitled a charitable deduction for the entire contribution, due to adjusted gross income limitations and the itemized deduction phase-out.

 

The Pension Protection Act of 2006 (the “Pension Act”) allows for federal tax-free distributions from an IRA to a charity, subject to the following provisions:

 

• Applies to IRA charitable rollovers in 2006 and 2007 only
• You must be at least 70½ years old
• Only assets from IRAs and Roth IRAs are allowed
• Distributions of up to $100,000 per year, tax-free
• Distributions must be made directly to a qualified public charity or private operating foundation
• Distributions will count toward minimum distribution requirement

 

Unlike federal law, which allows a deduction for contributions to an IRA, New Jersey does not — i.e., these contributions are subject to New Jersey gross income tax in the year made. Conversely, when you make a withdrawal from an IRA, the amount withdrawn is not taxable, but only to the extent of prior contributions that were taxed at the time made; while interest, dividends and capital gains credited to the IRA contributions are taxed upon withdrawal.[2] Consequently, although the Pension Act will not remove a New Jersey donor’s contribution from their income taxes by the state, it should still provide an overall tax savings to those individuals who take advantage of the favorable rules on the federal level.

 

Example: Madeline, age 74 and widowed, had a $2,380,000 IRA balance as of Dec. 31, 2005. She would like to donate money to the Jewish Community Foundation (“JCF”) in 2006. Scenario A: Madeline withdraws $100,000 from her IRA and keeps the funds. Scenario B: Madeline withdraws $100,000 from her IRA and then donates the entire amount to JCF (i.e., pre-Pension Act law). Scenario C: Madeline donates $100,000 directly from her IRA to JCF.
Income	Scenario A	Scenario B	Scenario C
Interest/Dividends	50,000	50,000	50,000
Net Short-term Gain or Loss	5,000	5,000	5,000
Net Long-term Gain or Loss	10,000	10,000	10,000
Social Security Benefits (taxable)	12,750	12,750	12,750
Other Pension and IRA Distributions	100,000	100,000	0
Adjusted Gross Income	177,750	177,750	77,750
Itemized Deductions:
Property Taxes: Residential	10,000	10,000	10,000
Charitable contribution to JCF	0	88,875*	0
3% Adjusted Gross Income Floor	(545)	(545)	(545)
Personal Exemption	2,816	2,816	3,300
Taxable Income	165,479	76,604	64,450
Total Federal Taxes	39,400	14,714	11,676
N.J. State Tax**	4,562	4,562	4,562
TOTAL TAXES PAID:	$43,962	$19,276	$16,238