Normally with a high income, you are not allowed to contribute directly to a Roth IRA nor to receive a deduction if you contribute to a traditional IRA. Regardless of income level though, you are allowed to make a nondeductible contribution to a traditional IRA.
When you have a nondeductible basis, IRS rules require that a portion of each distribution be composed of both nondeductible and traditional balances. Only the nondeductible portion escapes taxation.
You are required to prorate distributions as though all of your IRAs are mixed together and calculate which part is traditional and which part is nondeductible. The analogy is: Like you can’t take a sip of your coffee without getting part coffee and part cream so too you can’t withdraw from your IRA assets without getting part traditional and part nondeductible.
You report and track your IRA’s nondeductible basis on Form 8606. Only the amount initially contributed without a deduction is ever considered nondeductible. All IRA growth is counted as traditional IRA assets. For this reason, you get the fullest benefit of a backdoor Roth when you have no other traditional IRA assets.
With all of that in mind, I was recently posed the following question:
Can you benefit from giving QCDs out of your IRA when you have a nondeductible IRA balance?
QCD stands for Qualified Charitable Distribution. With a QCD, the IRS allows you to give up to $100,000 to charity directly from your individual retirement account (IRA) when you are over 70½ years old without counting the distribution as taxable income. QCDs are excluded from your taxable income on your 1040.
Luckily for the charitably-inclined individuals with nondeductible balances, QCDs are also excluded from your Form 8606 taxable and nontaxable calculations.
As IRS Publication 590-B says:
The amount of the QCD is limited to the amount of the distribution that would otherwise be included in income. If your IRA includes nondeductible contributions, the distribution is first considered to be paid out of otherwise taxable income.
This is also reflected in the Form 8606 instructions which reads:
Don’t include any of the following on line 7: …Qualified charitable distributions (QCDs). For details, see Are Distributions Taxable? in chapter 1 of Pub. 590-B.
This means that 100% of your QCD is treated as being sourced from pre-tax IRA balances unless there are not enough pre-tax IRA balances to cover the QCD.
If you do end up giving more than your pre-tax balance and dip into some of your nondeductible balance, don’t worry. That nondeductible portion cannot be a QCD, but Form 8606 will make it a nontaxable distribution anyway. You then have the option, as you always do, of itemizing that nondeductible charitable donation on your Schedule A.
The IRS explains this in their Publication 590-B example as well:
You can’t claim a charitable contribution deduction for any QCD not included in your income.
On December 23, 2018, Jeff, age 75, directed the trustee of his IRA to make a distribution of $25,000 directly to a qualified 501(c)(3) organization (a charitable organization eligible to receive tax-deductible contributions). The total value of Jeff’s IRA is $30,000 and consists of $20,000 of deductible contributions and earnings and $10,000 of nondeductible contributions (basis). Since Jeff is at least age 70½ and the distribution is made directly by the trustee to a qualified organization, the part of the distribution that would otherwise be includible in Jeff’s income ($20,000) is a QCD.
In this case, Jeff has made a QCD of $20,000 (his deductible contributions and earnings). Because Jeff made a distribution of nondeductible contributions from his IRA, he must file Form 8606 with his return. Jeff includes the total distribution ($25,000) on line 4a of Form 1040. He completes Form 8606 to determine the amount to enter on line 4b of Form 1040 and the remaining basis in his IRA. Jeff enters -0- on line 4b. This is Jeff’s only IRA and he took no other distributions in 2018. He also enters “QCD” next to line 4b to indicate a qualified charitable distribution.
After the distribution, his basis in his IRA is $5,000. If Jeff itemizes deductions and files Schedule A with Form 1040, the $5,000 portion of the distribution attributable to the nondeductible contributions can be deducted as a charitable contribution, subject to AGI limits. He can’t take the charitable contribution deduction for the $20,000 portion of the distribution that wasn’t included in his income.
This means that giving QCDs out of an IRA with nondeductible basis is actually a great way to reduce your pre-tax IRA assets, making way for a faster conversion of your post-tax nondeductible basis.
Photo by Tyler Nix on Unsplash