Q.: My dad makes charitable donations from his IRA and says it’s the best way to donate. I want to make a charitable donation from my 401(k) because selling an investment to raise cash to donate would trigger a gain. Unfortunately, they say I’d have to take a hardship distribution and then make the donation personally. Is this true for all 401(k)s?
A.: It is true that a donation from a 401(k) cannot be done on a completely tax-free basis. Hardship distributions are available on many 401(k) plans but that would only be an option if you could document a true hardship. Even if you could take a hardship distribution, you would not replicate the tax break your dad enjoys.
If they are saying you’d need to take a hardship distribution, it suggests you are younger than 59½ because many plans these days allow those over 59½ to take “in-service” distributions. An in-service distribution would allow you to move funds out of your 401(k) to an IRA. If you could do an in-service distribution and were over 70½, you could move 401(k) funds to an IRA and donate from there. More on that in a moment.
Assuming the hardship route is the only one available to you, say you took $20,000 out. That $20,000 is taxable plus there is a $2,000 penalty (10%) for being under 59½. If you turn around and cut a check to a charity for $20,000, the $20,000 is only fully deductible if you also have itemized expenses on Schedule A that exceed the standard deduction ($12,950 for singles, $25,900 for married filing joint returns in 2022). The $2,000 is not reduced by any deduction.
Read: 7 ways to make charitable giving more enjoyable in a down market
What your dad is doing is likely a Qualified Charitable Distribution (QCD). Taxpayers over age 70 ½ can make donations directly to a qualified 501c3 public charity from their IRA. Your dad can get the company holding his IRA to send $20,000 to a charity and exclude all $20,000 from his gross income which benefits him whether he itemizes or takes the standard deduction. He can donate up to $100,000 in total of pretax IRA funds to any number of charities each year completely tax-free. This direct donation capability applies only to IRAs.
Because the thing holding you back from selling the investment you mention in your question is tax on capital gains, you should consider another tax advantaged gifting technique. Instead of selling the investment, realizing a gain, and donating the proceeds, you should consider donating the shares in kind. Most charities have a brokerage account to accommodate gifts like this. Subject to some limits, you get the same charitable deduction you would otherwise but because the charity doesn’t pay taxes, the gain is never taxed.
Say, you have shares of XYZ that are worth four times what you paid for them. If you wanted to make a $20,000 donation and sold $20,000 of shares, you would have $20,000 cash available to give, would claim $20,000 as a donation, and would have realized a gain of $15,000.
If instead you donated the shares in-kind, you would still have $20,000 to claim as a donation but would not incur a capital gain. The charity could sell the shares for $20,000 cash, the same amount they would have if you cut a personal check. The charity, however, is tax exempt so they do not pay tax on the gain.
There are some quirks to donating shares but there is no age limit to making donations of appreciated holdings. However, generally, you are limited to claiming a charitable deduction of no more than 30% of your adjusted gross income in a particular tax year. If you get capped out, you can carry forward the excess for up to five years.
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Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.