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- Capital Purchase Plan Deadline Extended for Non-publicly-traded Banks
- "Opt Out" Date Extended for FDIC’s Temporary Liquidity Program
- Tax Free Charitable Distributions from IRAs
Capital Purchase Plan Deadline Extended for Non-publicly-traded Banks
On October 14, the U.S. Treasury announced terms on which it will purchase preferred stock of financial institutions, and stated a deadline of November 14 for banks to apply. Treasury has now clarified that this deadline applies only to publicly-traded institutions. On that basis, almost all of the banks headquartered in Oklahoma will now be able to wait longer for information specifically applicable to their own type of ownership structure, before being asked to make a decision.
An October 31 press release states, “Treasury will post an application form and term sheet for privately held eligible institutions at a later date and establish a reasonable deadline for private institutions to apply.” This is an important development, and should give Oklahoma banks a better chance to participate, on realistic terms. For now, there is no immediate pressure to make a decision, except for the very few publicly traded banks in Oklahoma, which are the only ones that remain bound by the original November 14 deadline.
There are several reasons why Treasury’s previously-announced terms do not work well for privately-held institutions:
(1) institutions that are not publicly held cannot issue preferred stock to the Treasury that would be publicly tradable and freely transferrable, as the previously announced term sheet requires, without going to major expense and effort;
(2) “subchapter-S” banks are only allowed to have one class of stock (common, but not preferred), so the earlier proposal did not fit them; and
(3) mutual institutions, such as mutual S & L’s and credit unions, cannot issue stock at all.
Treasury now plans to develop alternative proposals that can be used to increase capital of non-publicly-traded institutions.
“Opt-Out” Date Extended for
FDIC’s Temporary Liquidity Guarantee
FDIC has a new “Temporary Liquidity Guarantee Program” (TLGP) that is already temporarily effective (without cost) for all banks for at least a month, beginning October 14, 2008. Banks that do not “opt out” of the program by December 5 will automatically “opt in” and then must pay assessments related to either or both of the program’s two parts (whichever part(s) the particular bank does not “opt out” of).
1. Notifying the FDIC
Required Action Step: As stated in FDIC’s Temporary Liquidity Guarantee Program Interim Rule dated October 23, a bank must notify the FDIC if it wants to opt out of either or both halves of this guarantee program. (The deadline originally stated for notifying the FDIC was November 12. By announcement dated November 3 the deadline has now been extended to December 5 for notifying the FDIC if a bank wants to “opt out” of either or both of the program’s two parts.)
If a bank does nothing on or before December 5, its participation in both parts of the program will automatically continue, and it will be required to pay the related assessments.
To opt out of either or both parts of the program, a bank must communicate with the FDIC through www.fdicconnect.gov. (The FDIC states, “No paper submissions will be accepted.” Therefore, do not send a letter.) FDICconnect is a secure internet channel that insured institutions use to exchange information with FDIC.
In order to “opt out” of the TLGP, a bank must use the FDIC’s TLGP “Election Form,” which will be available through FDICconnect beginning on November 12. (To review a sample of the required Election Form, as well as instructions for filling it out, go to the FDIC’s website for the Temporary Liquidity Guarantee Program, which is www.fdic.gov/tlgp and click through the items found there that are dated November 3.)
(When the FDIC has received an Election Form from a bank, that bank will receive a confirmation page, displayed by FDICconnect, including a confirmation number. A bank that “opts out” must make sure a confirmation has been generated, or else it may become subject to assessment fees for participating in the guarantee program.)
The Election Form must be filled out by the bank’s Chief Financial Officer (or equivalent). The form can be used to “opt out” of both parts of the TLGP; to “opt out” of one part but “opt in” to the other part; or to “opt in” for both parts. As stated, a bank that “does nothing” will automatically “opt in” for both parts, without filling out the form; but in that case the FDIC will still want the financial information requested by the form, so it’s probably best to fill out the form, no matter what the bank’s decision may be.
For any bank not “opting out” of the FDIC guarantee for senior unsecured debt (discussed below), completing the form to indicate that the bank is participating will require disclosure of the bank’s “total amount of outstanding senior unsecured debt as defined in the regulation as of September 30, 2008, that is scheduled to mature on or before June 30, 2009.” (Any bank “doing nothing”—and therefore automatically “opting in”—will also eventually have to disclose this information.)
2. Summary of the Program
The two separate parts of the FDIC’s Temporary Liquidity Guarantee Program are as follows:
(a) a “transaction account guarantee program” (a temporary unlimited guarantee of all noninterest-bearing deposits in transaction accounts at an “opted-in” FDIC-insured institution, to the extent those deposits exceed the otherwise-available deposit insurance limits), and
(b) a “debt guarantee program” (for senior unsecured debt of participating banks or holding companies—including federal funds purchased).
(The FDIC’s interim rule covering both parts of this liquidity guarantee program is found at http://www.fdic.gov/news/board/TLGPreg.pdf and should be consulted for more detailed information. Or go to www.fdic.gov/tlgp and view all documents related to this program)
It is important for each bank to make a careful decision about what is right for it—because, once made, that decision cannot be changed. (A bank that “opts out” by December 5 cannot later “opt in”; and a bank that “opts in” now by doing nothing cannot later “opt out.”)
If a bank “opts in” for both programs (which is automatic, if a bank does nothing), that bank pays FDIC assessments for both programs. If a bank “opts out” of one program, it will pay assessments for the other program, only. If a bank “opts out” of both programs it will pay no assessments at this time.
However, when these two programs are ended, if the FDIC’s losses have exceeded assessments received, all insured institutions will be assessed to make up the difference.
For reasons explained below, my guess is that a very high percentage of Oklahoma banks will probably “opt in” for the “transaction account guarantee program.” And it’s possible that a majority of banks in Oklahoma will “opt out” of the “debt guarantee program”—but the right decision on that part may depend greatly on each bank’s particular circumstances and objectives. Both of these guarantee programs, and their fees, are outlined below in more detail.
3. “Transaction Account Guarantee Program”
The “transaction account guarantee program” provides an automatic FDIC guarantee (temporarily without cost, for the period from October 14 through November 12) with respect to all noninterest-bearing transaction account balances falling outside of regular FDIC insurance limits. A bank that does nothing or affirmatively “opts in” to the transaction account guarantee program by December 5 will pay a prorated guarantee assessment for the period from November 13, 2008, through December 31, 2008 (roughly one-half of a regular calendar quarter’s assessment), based on balance information disclosed in the bank’s December 31, 2008 call report. Going forward, a bank will be charged FDIC assessments on a quarterly basis, using call report information as reported for each of the four call report periods in 2009. This guarantee program ends on December 31, 2009–the same date that the FDIC’s temporary insurance limit of $250,000 ends.
The FDIC assessment rate for uninsured noninterest-bearing transaction account balances is ten basis points annualized (an annualized 1/10 of 1% on deposits covered by this program). The assessment will be billed at the rate of 2 ½ basis points per calendar quarter, multiplied by the bank’s “excess” noninterest-bearing transaction account balances for all customers at the end of that quarter. In dollars, the fee is $250 per calendar quarter for each $1 million of “excess” noninterest-bearing transaction account balances.
(The total “excess” balances reported on the call report each quarter will be determined as follows: Each depositor’s noninterest-bearing transaction account balances as of the call report date will be reduced by $250,000 to determine any “excess” balances for assessment purposes. All depositors’ “excess” balances will be added together. The resulting total will be a new information item on the call report form, and will be multiplied by 2 ½ basis points to determine the assessment fee per quarter for this part of the guarantee program.)
4. Calculating Available Coverage
A couple of clarifying points are needed here: First, the FDIC assessment fee mentioned above is being calculated in the manner explained above to keep things simple; but the amount of deposits covered by this FDIC guarantee and by the separate FDIC deposit insurance limits, combined, will always be determined in a manner that maximizes coverage under both approaches.
For example, assume a corporation has $1 million in noninterest-bearing transaction accounts and $250,000 in interest-bearing CDs. That company has only one $250,000 insurance limit; but the $250,000 will be applied first to interest-bearing deposits to the extent necessary to insure them, and the noninterest-bearing transaction account balances will still be fully guaranteed if the bank has “opted in.” In this example, a bank will pay a guarantee assessment on only $750,000 of noninterest-bearing deposits (the “excess” amount, calculated as set out above), but would actually have a guarantee on the full $1 million of noninterest-bearing deposits, while the $250,000 FDIC insurance limits will be applied to fully insure the $250,000 in interest-bearing CDs.
A second point to note is that “excess” noninterest-bearing transaction account balances held by public entities will result in an assessment fee to the bank even if securities are pledged on those balances. (A bank that has “opted in” should remove its pledging on these balances—as unnecessary–based on the FDIC guarantee (and fee) which are not optional.)
5. Includes “Official Checks”
FDIC points out that cashier’s checks and money orders are considered “demand deposits” of a bank, and therefore are included in the definition of noninterest-bearing transaction accounts. To calculate the amount of “excess” noninterest-bearing transaction accounts at the end of each calendar quarter, the bank must combine the amount of unpaid “official checks” owned by a customer with other noninterest-bearing transaction accounts of that same customer, and then deduct $250,000. If a bank “opts in” for this part of the guarantee program, any cashier’s check issued by the bank will have an unlimited FDIC guarantee.
6. Whose Deposits are Covered?
The noninterest-bearing transaction account guarantee program will be especially useful for deposits of businesses that are legally-separate entities (corporations, partnerships and LLCs). These businesses maintain noninterest-bearing transaction accounts because they cannot legally hold NOW accounts.
(The guarantee program applies to all types of depositors with noninterest-bearing transaction accounts—businesses, public entities, non-profits, individuals, etc.—but business depositors are the ones most likely to have uninsured deposit balances in such accounts. That’s true not only (1) because businesses cannot increase their insured deposits above $250,000 by “structuring” accounts to add joint tenants or beneficiaries, as individuals can, but also (2) because these businesses tend to have more total dollars of uncleared checks written, and therefore more “float,” in noninterest-bearing accounts.
For example, on a payday a larger company might deposit an amount exceeding $250,000 to its noninterest-bearing payroll account—resulting in part of its deposits being uninsured. If the bank then failed (with a high balance in the account), that depositor could have a loss (apart from the guarantee program). The same is true of a corporation’s or LLC’s main checking account, which could have large “unavailable” deposited balances as the result of deposits on a particular day, or a large amount of “float” due to checks not yet cleared. In recent months, businesses with balances exceeding the FDIC insurance limit have become nervous about such issues. The transaction account guarantee program can be an effective way to prevent a business customer from transferring higher-balance noninterest-bearing transaction accounts to other institutions.
7. Lobby Signs Required
By December 19, 2008 (extended from an earlier-announced deadline), each bank must post a prominent notice in its lobby (both in the main office and at each branch), “clearly indicating whether the [bank] is participating [or not] in the transaction account guarantee program.” If the bank is participating, the notice “must state that funds held in noninterest-bearing transaction accounts at the entity are insured in full by the FDIC.”
If a bank is not participating, the notice in each lobby and branch must advise that the bank is not participating in the transaction account guarantee program. This disclosure must be in simple, easily understandable language.
This requirement creates two potential problems: First, ordinary customers might not understand what the “negative” version of the notice means, but could become nervous because it sounds bad. Second, the notice may push certain business customers to switch their accounts to banks that are participating in the transaction account guarantee program. The FDIC also will be posting on its website a list of the banks that have “opted out” of the transaction account guarantee program.
For such reasons (apart from the program’s actual advantages), banks may feel that they are almost forced to “opt in” to the noninterest-bearing transaction account guarantee program.
Certainly some smaller banks have few or no customers with noninterest-bearing deposit balances that exceed the temporary FDIC insurance limit of $250,000. But this is not necessarily a reason to “opt out” of the guarantee program. (If a bank has very few deposits that would be covered by the guarantee, assessments related to the program will also be very low.) A bank that accepts coverage under the program (even if it feels it doesn’t need it) can avoid competitive disadvantage, and is also in a position to accept larger deposit balances from businesses later, if those appear.
8. “Debt Guarantee Program”
The other half of FDIC’s “temporary liquidity guarantee program” (for which a bank can “opt in” or “opt out” separately) involves an FDIC guarantee of “senior unsecured debt.” (“Senior” debt does not include subordinated debentures, for example; and “unsecured” excludes any of the bank’s or holding company’s debt that is fully or partially collateralized.) This part of the FDIC guarantee program is designed to overcome banks’ reluctance in recent months to lend to other banks on an unsecured basis.
What is covered by this guarantee? As defined by FDIC in 12 C.F.R. Section 370.2(e), “senior unsecured debt” must be evidenced by a written agreement, in a specified and fixed principal amount. It includes (1) “commercial paper” (usually issued by money center banks, regional banks, and their holding companies), and also (2) any nonnegotiable “certificates of deposit standing to the credit of a bank.” (At least in the past, banks sometimes purchased CDs of other banks, and often in amounts exceeding FDIC insurance limits.) “Senior unsecured debt” also includes certain longer-term (3) unsecured promissory notes (for example, issued by a holding company). But the category of “senior unsecured debt” that is most relevant to the typical Oklahoma bank is (4) “federal funds purchased.” This last category is the one most likely to influence an Oklahoma bank’s decision to “opt in” to this part of the FDIC program, if it does not “opt out.” (Debt payable to affiliates, including parents, subsidiaries and institution-affiliated parties, is excluded from this FDIC debt-guarantee program. For example, fed funds sold and purchased between two banks under common control would not be covered.)
Technically, “federal funds purchased” are unsecured overnight borrowings by a funds-purchasing bank, owed to a funds-selling bank. (Some banks also purchase fed funds on a “secured” based. However, secured fed funds, or partially-secured fed funds (if the secured and unsecured funds are not separately identifiable), are outside of this FDIC guarantee program’s coverage and are not affected by it.)
Certainly in the past (and probably in the future), funds-selling banks have at times been reluctant to lend fed funds to purchasing banks that have higher levels of asset-quality problems; and those that were still willing to lend typically imposed a higher fed-funds borrowing rate. As even the last few months have demonstrated, a bank’s inability to purchase fed funds on an unsecured basis can greatly increase, and certainly does not help to solve, a bank’s liquidity problems.
a. Advantages and Disadvantages. Following are some of the potential advantages of “opting in” to the FDIC’s guarantee of “senior unsecured debt” (including fed funds purchased): (1) For so long as a bank’s fed funds purchased are guaranteed by FDIC, the fed funds seller will have no hesitancy in lending those funds—even if the purchaser’s asset quality or capital later declines. This guarantee is basically an assurance of being able to purchase fed funds, “no matter what”—within the limit allowed to the bank by FDIC. (2) All banks with this guarantee in place should be fairly equal as to the rate they must pay to purchase fed funds, because “risk level” is based on the FDIC’s guarantee, not the purchasing bank’s condition. (3) Once this guarantee program is in place, fed funds lenders may begin to “stratify” the funds rates they require, so that banks with the guarantee in place can obtain funds at one rate, and other banks may have to pay a higher rate. (But even if different rates develop, it’s unclear whether the difference in rate would be anywhere near as high as the FDIC guarantee fee on such funds, explained below.)
The banks that perhaps may see the largest potential disadvantage in “opting in” to FDIC’s senior unsecured debt guarantee are those that regularly borrow large amounts of fed funds, that feel they don’t need the guarantee to borrow such funds, and that believe the FDIC assessment rate (an annualized 75 basis points fee, discussed below) is too high, if applied to all fed funds purchased by them.
For a bank that rarely if ever purchases fed funds, I would say it’s an easier case to justify “opting in,” instead of “opting out.” Certainly, the bank may think, “We don’t need this program”—and if not, fine. But the counter-argument is, “O.K., it will cost you nothing to ‘opt in’ if you truly never intend to purchase fed funds. So why not do it? If you never need it over the next seven months, that’s fine and you’re done. But circumstances in the financial system are changing rapidly. If it turns out that you can use this guarantee program in several months won’t you be glad to have it available? And if you still use it only infrequently, it still won’t cost much.”
b. Effective Dates. The debt-guarantee part of FDIC’s temporary liquidity guarantee program covers only “senior unsecured debt issued by a participating entity on or after October 14, 2008, and on or before . . . June 30, 2009.” Fed funds, of course, have a maturity of “one business day,” so the last day a bank can issue fed funds guaranteed under this program will be June 30, 2009, and those funds would mature on July 1, 2009. But other types of financial institution debt instruments (such as commercial paper or unsecured promissory notes of a holding company) can have a maturity of from several months to several years after issuance. And for that reason, this guarantee program has a “roll-off period”: Longer-term “senior unsecured debt” issued on or before June 30, 2009 will remain guaranteed until the debt’s actual maturity date, but not past June 30, 2012, whichever occurs first.
c. Authorized Guaranteed Debt Limit. The FDIC guarantee program has a built-in limit on how much senior unsecured debt can be issued by a financial institution (outstanding at any one time) and described as “guaranteed”: “[T]he maximum amount of debt to be issued under the guarantee is 125 percent of the par value of the [bank’s] senior unsecured debt, excluding debt extended to affiliates or institution affiliated parties, outstanding as of September 30, 2008 that was scheduled to mature on or before June 30, 2009.” This amount existing at September 30 is the number a bank must report to the FDIC in filling out the Election Form, to participate in the debt guarantee program. (A bank must disclose the amount at September 30, even if was $0.)
For example, if a bank “opts in” to the debt guarantee program but had no senior unsecured debt outstanding on September 30, 2008 other than fed funds purchased, the amount to fill out on the form would simply be the amount of fed funds purchased on that date. To illustrate, let’s say that was $800,000. This bank (having “opted in”) would be automatically authorized to issue “guaranteed” senior unsecured debt totaling 125% of the amount outstanding on September 30. This particular bank could have FDIC-guaranteed fed funds purchased up to $1,000,000 outstanding at any one time (125% of $800,000), assuming that no other type of senior unsecured debt used up any part of the limit, during the period from October 14, 2008, through June 30, 2009, as necessary.
If a bank had a $0 balance of federal funds purchased (and no other senior unsecured debt outstanding) on September 30, 2008, that bank is still able to “opt in” to the debt-guarantee program by December 5. However, for an actual balance of $0 outstanding on September 30, 125% of $0 is still $0. So the bank would start out with no authorization amount. In this situation, a participating entity is able to apply to FDIC for some dollar amount of senior unsecured debt authority that would be covered by the FDIC guarantee. FDIC, after consulting with the bank’s primary federal regulator, will then decide whether, and to what extent, such request will be granted, on a case-by-case basis. (If a bank is in good condition and requests an authorization level that is primarily intended to provide back-up liquidity on a temporary basis when needed, a bank’s request will probably be approved.)
b. Guaranteed vs. Non-guaranteed. If a bank “opts in” to the debt guarantee program, the amount for which it is then authorized could become somewhat like a two-edged sword: On the one hand, it’s great to this authority available. On the other hand, the “opt in” leaves the bank unable to choose between issuing “guaranteed” or “non-guaranteed” unsecured debt.
(If the bank issues unsecured debt—such as fed funds purchased—after “opt in,” that debt will be automatically FDIC-guaranteed, and the bank will pay a related FDIC assessment fee for issuing the debt. Only during times when the FDIC authorization has been used up by already-outstanding unsecured debt, will the bank then be allowed to issue senior unsecured debt that is not guaranteed.)
Applying this to fed funds, a bank might have available sources for purchasing fed funds on a certain date on either a guaranteed or non-guaranteed basis, and at somewhat different rates. Based on the funds pricing, and taking the cost of the FDIC guarantee into account, the bank might prefer to purchase the non-guaranteed fed funds. However, a bank that has “opted in” will not have this choice. It must first purchase fed funds on a guaranteed basis, up to its full authorized limit; and if it then needs to purchase additional fed funds on the same day, it can (and must) purchase the excess amount “non-guaranteed,” while clearly disclosing this “non-guaranteed” status of the funds to the seller.
However, even a bank that has “opted in” for the debt guarantee program can still decide whether it wants to purchase fed funds on a secured basis (avoiding the guarantee), instead of purchasing fed funds unsecured (which automatically triggers the FDIC guarantee and the related assessment fee).
c. Assessment Rate. The FDIC assessment fee for the “debt guarantee program” is an annualized 75 basis points (three-quarters of one percent, annualized, calculated on whatever amount of senior unsecured debt (including fed funds purchased) may be outstanding from time to time and guaranteed under the program). A bank (or holding company) must notify the FDIC (by means of FDICconnect) of the amount of any senior unsecured debt that it has described as “guaranteed,” as that debt is issued.
For example, a bank must notify the FDIC (1) of the fact that unsecured, guaranteed federal funds have been purchased, (2) the duration of those funds, and (3) the dollar amount. If a bank purchases $1,000,000 of “guaranteed” federal funds for one day, the annualized fee payable to the FDIC on that amount would be $7,500, and the daily fee (1/365 of the annual amount) would be about $20.52.
Based on information in FDIC’s November 3 extension announcement, the debt-guarantee assessment will not apply to overnight funds (fed funds) outstanding on dates before December 6, 2008. (The originally announced “free coverage” period was to expire on November 12.)
If a bank regularly purchases fed funds, paying the 0.75% assessment fee on top of the current 1.00% target fed funds rate (for a total of 1.75%) may seem expensive. Whether this is acceptable (although not ideal) may depend on the bank’s other available funding alternatives—and whether the bank has securities available to pledge on “secured” fed funds instead, thereby avoiding the fee altogether.
Of course, as suggested above, if a bank purchases federal funds only infrequently (for example, as an emergency or back-up liquidity source), the availability of the FDIC guarantee (by “opting in”) can increase the bank’s comfort that it will be able to purchase federal funds whenever needed—and having this assurance costs nothing during periods when the borrowing capability goes unused.
If a bank issues senior secured debt that is guaranteed under the program, it must be careful not to issue too much debt described to sellers as “guaranteed.” If a bank exceeds its authorized limit for guaranteed senior unsecured debt outstanding at one time, and does not disclose that the “extra” amount (the last-issued amount) is “not guaranteed,” the FDIC will penalize the bank by increasing its assessment rate to 150 basis points instead of 75 basis points, and may also impose civil money penalties.
d. Non-refundable Fee. On the OBA’s call-in program on Friday, October 31, I mentioned a “nonrefundable fee” for participating in the FDIC’s debt guarantee program. However, after reading the provisions further, it appears that the regulation’s “nonrefundable fee” of 37.5 basis points times the amount of “senior unsecured debt” that a bank had outstanding on September 30, 2008, will only apply to a bank that intends to issue certain “long-term” unsecured debt. This fee will not apply to a bank that only uses the FDIC guarantee program for “fed funds purchased.”
9. More Questions
The FDIC’s “Frequently Asked Questions” on the TLGP, last updated on November 3, can be found at www.fdic.gov/tlgp and will provide a lot of additional information on both parts of FDIC’s guarantee program. Banks are also encouraged to send an e-mail to tlgp@fdic.gov if they have other questions about the program.
Tax-Free Charitable Distributions from IRAs
One of the expiring tax provisions extended by October’s federal “bailout” legislation is Section 408(d)(8) of the Internal Revenue Code. This provision allows tax-free distributions from an individual’s IRA, if paid directly to any IRS-recognized charity.
During calendar years 2006 and 2007, an IRA owner who was at least 70 ½ years old was allowed to make direct transfers from his IRA to a charity, without including those distributions in taxable income. This provision expired at the end of 2007, but has now been extended to allow charitable distributions of up to $100,000 per year from an IRA in calendar years 2008 and 2009.
To take advantage of this provision, the IRA owner cannot receive the distribution of the money himself. (The withdrawn funds should not be in cash, nor deposited to the individual’s account, nor payable to him.) One way to meet the requirement is for the bank to transfer the distributed funds directly from the IRA to the designated charity. (The bank can mail a check to the charity.) However, IRS guidance issued in 2007 also permits a bank to give the IRA owner a check payable to the charity, allowing the IRA owner himself to deliver or mail the check. (For example, a cashier’s check could list the remitter as “John Doe IRA” and the payee as the charity.)
As discussed below, it is possible for even the average person (70 ½ or older) to take advantage of the “charitable distribution” provisions (usually resulting in reduced taxes, even when the charitable distributions made from the IRA are no larger than the contributions that the person otherwise would have made from his own pocket).
1. Charitable Gift of the RMD
IRA customers over 70 ½ must take an annual “required minimum distribution” (RMD) from an IRA—whether they want to or not. If someone wants to avoid including the RMD in income, and doesn’t need the money, he can certainly instruct the IRA custodian to make a distribution from the IRA directly to a charity. The result is that (1) any amount distributed in this manner (up to the full amount of the RMD) will be counted toward satisfying the RMD requirement, but will not be included in the customer’s income for annual income tax purposes.
For example, assume that an IRA owner is required to take an RMD of $3,500 by the end of calendar year 2008—but has adequate other funds available and does not really need funds from the IRA to pay bills. So he asks the bank to transfer $3,500 directly to one or more charities of his choice—for example, the Oklahoma Medical Research Foundation. If he transfers $3,500, that will exactly use up his RMD–and he will have no taxable income distributed from the IRA for 2008, except any income resulting from other distributions he takes in 2008.
2. Maximizing the Distribution
Of course, an individual also can make a charitable distribution that is larger than the RMD (up to $100,000 total) or smaller than the person’s RMD for the year. (It’s important to recognize that an amount directly transferred from an IRA to a charity not only will not count as income, but also cannot be counted as a charitable deduction on the individual’s tax return.)
A husband and wife can make charitable IRA distributions of up to $100,000 each (resulting in a doubled contribution amount available), but each person’s distributions must come from his/her own available IRA funds.
3. Smaller Charitable Distributions
Most IRA owners (70 ½ or older) can benefit by using the IRA charitable distribution provision, even if they use it in a fairly small amount—as the following example illustrates.
Let’s assume that a person ordinarily makes contributions of $2,000 per year to the church—and that he would contribute the same amount regardless of whether the contributions come from his IRA or from other funds. Additionally, assume that he has been taking annual distributions from his IRA to cover living expenses (to supplement Social Security income), and then writing checks totaling $2,000 to the church during the year. But instead of this, the IRA owner instructs the bank to make distributions totaling $2,000 directly to the church, from his IRA.
This change (making a $2,000 charitable distribution from the IRA) has two results: First, the $2,000 distributed directly from the IRA to the church will not count as taxable income to the individual. Second, the $2,000 distribution to the church cannot be deducted by the individual as a charitable contribution. For some people, these two changes will offset each other, resulting in no change in net taxable income. But for many individuals, taxable income will actually decrease by $2,000 as a result of these steps, as I will explain:
Let’s assume that this person was already taking the “standard deduction” on his federal tax return–because he doesn’t have enough total deductions to be able to itemize them. (A single IRA owner (at least age 65) had a “standard deduction” of $6,650 in 2007 for federal income tax purposes, but married couples filing jointly (age 65 or more) had a $12,800 “standard deduction” in 2007.)
For this person, it may not matter that the $2,000 paid to the church (by means of a charitable distribution from his IRA) can’t be taken as a charitable deduction: Perhaps he didn’t have enough total deductions to be able to “itemize” his deductions before, when he was making the contribution to the church from other funds; and he still can’t itemize, when he becomes unable to deduct this contribution to the church; so both ways, he just takes the “standard deduction.”
But the important point is, his taxable income goes down by $2,000, because the distribution from the IRA to the church does not count as income received by the individual. Net result—the individual’s tax is reduced by however much federal (and state) income tax he otherwise would have paid on $2,000 of income. There is no change in “who gets what”—the church still gets the $2,000, and $2,000 still comes out of the IRA—but the individual pays less tax (perhaps $500 in federal and state income tax savings, combined, or a bit more) by making a charitable distribution from the IRA rather than paying the church directly from his bank account—assuming that the person was taking a “standard deduction” anyway. Anyone who is 70 ½ can do this, in both 2008 and 2009.
4. Larger Charitable Distributions
Although the vast majority of IRA customers do not fall into the higher-income category, the special provisions for direct transfer from an IRA to a charity can be even more useful for higher-income individuals than for the “ordinary” IRA owner just described. Following are two of the most important benefits for wealthy persons:
First, the IRS Code limits an individual’s deductible charitable contributions in one year to 50% of that person’s net taxable income, measured before the charitable deduction is taken. However, a charitable distribution from an IRA (up to $100,000 annually) is totally “off the slate” and does not reduce the individual’s separate ability to donate to charity (and deduct) an amount as large as half of the net taxable income reportable on his tax return. For this reason, a person who makes a charitable distribution from his IRA has the ability to make much larger total charitable contributions, on a tax-favored basis, than would otherwise apply. (If the economy weakens, many charities will be hurting, and larger donors’ willingness to help may be favorably influenced by the extended availability of this particular IRA provision.)
Second, taking a large distribution from an IRA would normally have a negative tax impact not only because the IRA distribution would be taxable, but also because receiving too much income may cause the individual’s other allowable deductions and tax credits to phase out. But because a charitable distribution from an IRA is not included in the individual’s “adjusted gross income,” there is (1) no income tax payable because of the distribution, and (2) no resulting decrease in the individual’s other available deductions or tax credits.
Of course, an individual (70 ½ or older) should consult a tax professional for advice in this or any other situation where complicated tax-planning issues may be involved.