ATRA 2012: In-plan Roth conversions and tax-free IRA charitable contributions

Retirement Provisions in the American Taxpayer Relief Act of 2012

The American Taxpayer Relief Act of 2012 (ATRA), enacted to avoid the fiscal cliff, includes two provisions that may be important to certain IRA owners and retirement plan participants. The first extends tax-free charitable contributions from IRAs through 2013, and the second liberalizes the rules for 401(k), 403(b), and 457(b) in-plan Roth conversions.

Background

The Pension Protection Act of 2006 first allowed taxpayers age 70½ or older to exclude from gross income otherwise taxable distributions from their IRA (“qualified charitable distributions,” or QCDs), up to $100,000, that were paid directly to a qualified charity. The law was originally scheduled to expire in 2007, but was extended through 2011 by subsequent legislation. The law has just been extended yet again, retroactively to 2012 and through 2013, by ATRA.

How QCDs work for 2012 and 2013

You must be 70½ or older in order to make QCDs. You direct your IRA trustee to make a distribution directly from your IRA (other than SEP and SIMPLE IRAs) to a qualified charity.* The distribution must be one that would otherwise be taxable to you. You can exclude up to $100,000 of QCDs from your gross income in each of 2012 and 2013. If you file a joint return, your spouse can exclude an additional $100,000 of QCDs in 2012 and 2013. Note: You don’t get to deduct QCDs as a charitable contribution on your federal income tax return–that would be double-dipping.

QCDs count toward satisfying any required minimum distributions (RMDs) that you would otherwise have to receive from your IRA, just as if you had received an actual distribution from the plan. However, distributions that you actually receive from your IRA (including RMDs) that you subsequently transfer to a charity cannot qualify as QCDs.*

Example: Assume that your RMD for 2013, which you’re required to take no later than December 31, 2013, is $25,000. You receive a $5,000 cash distribution from your IRA in February 2013, which you then contribute to Charity A. In June 2013, you also make a $15,000 QCD to Charity A. You must include the $5,000 cash distribution in your 2013 gross income (but you may be entitled to a charitable deduction if you itemize your deductions). You exclude the $15,000 of QCDs from your 2013 gross income. Your $5,000 cash distribution plus your $15,000 QCD satisfy $20,000 of your $25,000 RMD for 2013. You’ll need to withdraw another $5,000 no later than December 31, 2013, to avoid a penalty.

Example: Assume you turned 70½ in 2012. You must take your first RMD (for 2012) no later than April 1, 2013. You must take your second RMD (for 2013) no later than December 31, 2013. Assume each RMD is $25,000. You don’t take any cash distributions from your IRA in 2012 or 2013. On March 31, 2013, you make a $25,000 QCD to Charity B. Because the QCD is made prior to April 1, it satisfies your $25,000 RMD for 2012. On December 31, 2013, you make a $75,000 QCD to Charity C. Because the QCD is made by December 31, it satisfies your $25,000 RMD for 2013. You can exclude the $100,000 of QCDs from your 2013 gross income.

As indicated above, a QCD must be an otherwise taxable distribution from your IRA. If you’ve made nondeductible contributions, then normally each distribution carries with it a pro-rata amount of taxable and nontaxable dollars. However, a special rule applies to QCDs–the pro-rata rule is ignored and your taxable dollars are treated as distributed first. (If you have multiple IRAs, they are aggregated when calculating the taxable and nontaxable portion of a distribution from any one IRA. RMDs are calculated separately for each IRA you own, but may be taken from any of your IRAs.)

Why are QCDs important?

Without this special rule, taking a distribution from your IRA and donating the proceeds to a charity would be a bit more cumbersome, and possibly more expensive. You would need to request a distribution from the IRA, and then make the contribution to the charity. You’d receive a corresponding income tax deduction for the charitable contribution. But the additional tax from the distribution may be more than the charitable deduction, due to the limits that apply to charitable contributions under Internal Revenue Code Section 170. QCDs avoid all this, by providing an exclusion from income for the amount paid directly from your IRA to the charity–you don’t report the IRA distribution in your gross income, and you don’t take a deduction for the QCD. The exclusion from gross income for QCDs also provides a tax-effective way for taxpayers who don’t itemize deductions to make charitable contributions.

*Special rules for 2012

Because the QCD rules were extended retroactively to 2012, two special rules apply:

• You may elect to treat any QCDs you make during January 2013 as having been made on December 31, 2012. This allows you to make QCDs in January 2013 and have them apply against your 2012 $100,000 limit.
• If you received a distribution from your IRA during December 2012 (even if the distribution is an RMD), you may elect to treat all or part of that distribution as a QCD if you transfer the cash to a qualified charity no later than January 31, 2013.

It’s expected that the IRS will issue guidance in the near future describing how and when your election must be made.

ATRA also makes it easier to make Roth conversions inside your 401(k) plan (if your plan permits).

A 401(k) in-plan Roth conversion (also called an “in-plan Roth rollover”) allows you to transfer the non-Roth portion of your 401(k) plan account (for example, your pretax contributions and company match) into a designated Roth account within the same plan. You’ll have to pay federal income tax now on the amount you convert, but qualified distributions from your Roth account in the future will be entirely income tax free. Also, the 10% early distribution penalty generally doesn’t apply to amounts you convert.

While in-plan conversions have been around since 2010, they haven’t been widely used, because they were available only if you were otherwise entitled to a distribution from your plan–for example, upon terminating employment, turning 59½, becoming disabled, or in other limited circumstances.

ATRA has eliminated the requirement that you be eligible for a distribution from the plan in order to make an in-plan conversion. Beginning in 2013, if your plan permits, you can convert any part of your traditional 401(k) plan account into a designated Roth account. The new law also applies to 403(b) and 457(b) plans that allow Roth contributions.