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How The IRS Discourages Boomer Charity

The Messenger

November 13, 2023

Americans like to call ourselves the most generous nation on earth — but charitable giving is on the decline. In 2022, it fell 3.4% (10.5% when adjusted for inflation) to fall under $500 billion. It was only the fourth such decline in 40 years. What’s more, individual giving —  distinguished from that of foundations and corporations — declined at an even greater rate, falling 6.4%, or 13.4% inflation-adjusted.

There are a wide range of explanations for the drop, including a rocky stock market and the ongoing effects of the Tax Cuts and Jobs Act of 2017. The latter — its many virtues aside — has led some 90% of taxpayers to file for the “standard” deduction, eliminating their incentive to itemize and thus reduce their taxes through charitable giving.

There is, however, the potential for a generational flood of generous giving to arise — were it not for arcane and illogical IRS rules that inhibit it. As baby boomers hit their 70s, they find themselves suddenly required to start drawing cash out of their 401(k)s and IRAs. These “required minimum distributions” are substantial: traditional IRAs and 401(k)s and 403(b)s (for nonprofit employees) hold an estimated $14 trillion. That implies a looming tax liability of some $2 trillion. But diverting even a small percentage of that away from Washington and toward the thousands of charitable nonprofits of American civil society is discouraged by the tax code.

Monies required to be withdrawn from retirement accounts must, by law, be taxed as income. That’s because they’ve not been taxed previously; putting aside funds in “tax-advantaged accounts” reduces income at the time they’re deposited. They are, instead, taxed upon “distribution” — and not unfavorably for retirees, who may well find themselves in a lower tax bracket than when they were working.

But directing some of those withdrawals to charitable giving does not mitigate that tax bite. Donations must be made with income after taxes have been paid on it. The charitable deduction will not likely reduce the tax bite — because so few taxpayers now itemize.

There is one exception, however, but it’s arbitrarily limited. Those withdrawing funds from personal IRAs — those not sponsored by former employers — are allowed to make “qualified charitable distributions.” By sending donations directly from their retirement accounts to a charity, they avoid being taxed on the income.

But, for no obvious reason, the same rule does not apply to the huge looming distributions from employer-sponsored 401(k)s or 403(b)s. For context, 401(k)s alone hold more than $6 trillion for 60 million plan participants. There is no obvious reason why such accounts should not be able to make direct, qualified charitable distributions. Funds held in them were not taxed previously, to be sure — but neither were those in personal IRAs.

Worse still, neither IRA nor 401(k) account holders may direct their required distributions to the fastest-growing vehicles for charitable giving: donor-advised funds, or DAFs. These personal charitable giving accounts — mini-foundations, if you will — now number 1.2 million, a 28.5% increase since 2017. When one transfers appreciated stock or ordinary income to a DAF, a tax deduction is permitted. Not so when transferring a 401(k) distribution; one must pay taxes first.

Again, there is no logic here. Funds held in DAFs may not be used for any purpose other than charitable giving. They can be invested and grow in value — but the increase, too, may be used only for charitable giving — whether by the original donor or by heirs. They are, in effect, small family foundations, most of them overseen by arms of some of the largest financial firms:  Vanguard, Fidelity and Schwab.

It is not controversial to say that America faces myriad social problems, whether at the local or national level. It should not be controversial to say that Washington may not know best how to address or mitigate them. That’s why the tax code has always encouraged charitable giving.  Today, it should be updated to reflect changed ways in which Americans save — or encourage them to give, as well.