Without Pease, Does a QCD Make Sense?
Yes, that is Pease, not peace.
Donald Pease was a Congressman from Ohio who inserted a “stealth tax” into the Omnibus Reconciliation Act of 1990. The purpose of this Pease limitation was to raise revenue by limiting itemized deductions for high income earners. The limitation kicked in at a certain level of Adjusted Gross Income (AGI). Income in excess of those amounts triggered a reduction in itemized deductions that were actually deductible.
Thus, if your income exceeded those amounts, you did not get your full charitable contribution deduction. You also did not get your full mortgage interest, state and local tax, or miscellaneous deductions. Your deductions were limited. If you look at the bottom of Schedule A in your 2017 income tax return, you will see Line 29, which says:
Is Form 1040, line 38, over $156,900?
__ No. Your deduction is not limited…
__ Yes. Your deduction may be limited…
Line 38 is your AGI. Thus, if your AGI exceeded that amount, you probably did not get the full amount of your charitable contributions and other itemized deductions.
It is called a “stealth tax” because it’s very sneaky, and it’s not even fully disclosed how much your deductions have been reduced. In order to figure it out, if the “Yes” box is checked, you have to add up all the numbers in the right hand column of Schedule A and then subtract the number on line 29. The difference is the amount of your itemized deductions that have been disallowed.
The good news is the Pease limitation was repealed by the new 2017 tax law (the “Tax Cuts and Jobs Act”). However, this repeal expires in 2025 unless Congress extends it.
If you are 70-1/2 or older, you may be aware that you have the option to donate up to $100,000 each year directly from your IRA to a charity. This is called a Qualified Charitable Distribution from an IRA.
This made a lot of sense during the era of Pease.
Because the QCD avoided the inclusion of the IRA distribution into income, and it also guaranteed you would get the full value of that charitable contribution. It would not be subject to the Pease limitation. To be clear, the IRA withdrawal is not taxed, and there is no charitable deduction. But the net effect is that your taxable income is lower by doing the QCD.
If you were to withdraw from the IRA and then write a check to a charity for the same amount, that withdrawal would be taxable income that would drive up your AGI, and the Pease limitation would limit your charitable contribution.
Now that there is no more Pease, does the QCD still make sense?
The reason it makes sense is that there are other tax breaks or tax penalties that are tied to high AGI. Here are three important ones:
1) Medical expenses – As you probably know, medical expenses are still deductible as an itemized deduction, but only if your medical expenses exceed 7.5% of AGI. Thus, if you can take steps to reduce AGI, this will enable more of your medical expenses to be deductible. A QCD avoids the amount of the charitable IRA withdrawal from increasing AGI.
2) Real estate losses – Many high earners do not realize that their rental real estate losses may not be deductible. Generally, you are allowed to deduct up to $25,000 of losses from rental real estate in which you actively participate. However, that amount is phased out for incomes between $100,000 and $150,000. This results in no deduction if your modified AGI exceeds $150,000. (This rule does not apply to real estate professionals.) Disallowed losses do get carried forward to future years. That said, a QCD again can help reduce AGI and help qualify for this deduction.
3) Net Investment Income Tax – This NIIT is also known as the 3.8% Medicare tax. It is a tax levied on investment income. Most high earners have investment income of some sort. The NIIT is a surtax that was created as part of the Affordable Care Act in 2013. It imposes a tax on interest, dividends, capital gains, business income (passive), and rental income. It also applies to the gain on the sale of your house, in excess of the $250k/$500K exemption. The NIIT only applies to people with AGI of $200,000 (single) or $250,000 (joint). It is complicated, but the point here is that a QCD can help to keep AGI lower.
There may be other taxes or tax benefits that are affected by your AGI level. It is important to keep AGI low. Therefore, a QCD still makes sense for taxpayers with high incomes.
For those who are eligible, a Qualified Charitable Distribution from an IRA still makes good financial sense, despite the repeal of the Pease limitation.
In order to take advantage of certain tax benefits that are pegged to Adjusted Gross Income, it is critical to keep AGI as low as possible. A QCD accomplishes that. It should be utilized where possible.