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Deferring taxes is one of the best ways Americans have to improve their investment returns. And people have noticed: the first advice most people get when they join the workforce is to max out their contributions to their Individual Retirement Accounts (IRAs).
IRAs are trust accounts with tax advantages that individuals can open to save and invest for their retirement: assets in your IRA grow tax free until you withdraw your money. Why are tax deferred accounts such a big deal? Because contributions can be made pre-tax and by avoiding up-front taxes, you get to reinvest and grow your tax savings.
As an example, A 35-year old who invests into a traditional IRA and grows her investment at 8% per year until she is 60 might increase her returns by more than 70% versus if she had invested that money in a normal taxable investment account due to the benefits of tax deferral.
Passing on IRA assets between generations
The largest wealth transfer in history is expected over the next two decades: About $30 trillion will pass from Baby Boomers to Millennials. As this happens, both generations will be looking at how to best pass on those assets with efficient tax planning structures.
Historically, one of the best ways to pass on assets between generations was for parents to pass on their IRA to their children’s IRA in what was called a Stretch IRA. The parent’s IRA would roll over into the children’s IRA, and the kids could therefore continue to allow the assets to grow tax free until they were 59.5, when they would be required to start taking distributions. However, in 2020 the Secure Act was significantly constrained this and changed the rules of how IRA’s could be passed on, with two major implications:
This means if you inherit your parents IRA, you may now have to pay more than 50% of the IRA to taxes, significantly reducing the value of your parents hard earned savings.
But there are two great replacements that are nearly as powerful as the Stretch IRA at maximizing how much money is passed on from a parents IRA to their children or grandchildren:
As a quick overview, a Charitable Remainder Trust is a tax exempt trust that allows you to sell appreciated assets and defer the associated income taxes until you receive a distribution, thereby growing your money faster with the magic of compounding — kind of like a different version of an IRA.
A charitable remainder trust distributes income to the trust beneficiaries (usually you and/or your family) for a specified period — up to 20 years or the length of your and others lifetime — and, when that period is over, donates the remainder — everything that hasn’t been distributed yet — to your chosen charity.
When and how to set up an IRA-to-CRUT rollover?
As with most tax planning, the answer to “when?” is “now.” The benefits of this strategy come into play as soon as you pass away, but implementing it requires planning in advance. To ensure that your IRA is correctly moved into your beneficiaries’ trust, you’ll need to establish a “testamentary CRUT” now.
A testamentary trust is one that comes into effect upon an individual’s passing. In this case, you can establish such a trust and designate it as the beneficiary of your IRA. That way, when you pass away, the IRA’s funds will go straight into the trust with no special maneuvering — and, critically, no legal wrangling in probate.
Aside from whether to pursue the IRA-to-CRUT strategy and when to implement it, there are several key design questions you’ll want to answer as soon as you decide this plan is for you.
A Roth conversion has two virtues: Simplicity and front-loading taxes. With a Roth conversion, an IRA owner can transfer assets from a traditional retirement account (a traditional IRA, 401(k), SEP IRA, or SIMPLE IRA, for example) into a Roth IRA.
What is the benefit of this move? Traditional retirement accounts are tax deferred; you put in pre-tax money and then pay taxes when you make withdrawals. With Roth IRA, by contrast, you put in post-tax dollars — that is, you pay taxes up front — but then you get to make tax-free withdrawals.
When you convert a traditional retirement account into a Roth IRA, you must pay income tax on the money you convert, but you and your heirs will be eligible for tax-free withdrawals (instead of paying ordinary income tax rates) — the key benefit of a Roth account — in the future assuming the account has been open at least five years.
There are certainly a variety of benefits to each approach. Let’s take a look at a couple of key tradeoffs: timing and optionality.
Roth Conversion: The Roth conversion is simple — pay your taxes now and you may gift your IRA to your heirs free and clear of taxes and liquidity constraints. The tradeoff for that simplicity and those financial benefits is that you have to act soon. In fact, a Roth conversion will typically make sense only if you expect to live another 15 years or more; otherwise, you’re just choosing to take on a big tax bill today with no real payoff. And if you do act today, the move is irreversible — you’re paying a large tax bill today in exchange for lower taxes in the future, and that means sending a big, non-refundable check to the government — as much as 35% or more of the value of your IRA.
A Roth conversion can make sense for people who:
Charitable Remainder Trust Rollover: A Charitable Remainder Trust, by contrast, is a much more flexible option as there’s no commitment today and no negative implications tied to when you pass away or upfront taxes to pay. If you decide that a trust might make sense, set it up, and then change your mind later, that’s fine — there’s no up-front tax consequences and no need to move your assets. This strategy is fully reversible until the end of your life and delivers a significant ROI as well.
An IRA-to-CRUT rollover can be a fit for people:
Louis and Maria are 70-year-old New York residents. They’ve never had a huge windfall, but they’ve saved conscientiously, and they’ve put together a retirement they’re comfortable with. As a result of that careful planning, they have a traditional IRA that is worth $1 million today, and they don’t expect to need that money. They’d like to give it to their kids when they pass away.
Comparing the numbers
Option 1: IRA to CRUT
Current value and growth: with the assumptions of above, the account will be worth about $2.39 million when they pass away — they’re already about $900k ahead of the Roth conversion, because they didn’t have to pay those up-front taxes.
Tax deferral: the money then goes into a CRUT. Because the CRUT is tax exempt, the couple’s children will pay no taxes on the inheritance at that point; instead, they’ll get to reinvest the full $2.39 million. Assuming 7% growth from there on out (plus occasional distributions to cover expenses), that $2.39 million would turn into $7.45 million over a 30-year period.
Option 2: Roth Conversion
After taxes: if Louis and Maria convert their traditional IRA to a Roth today, they’ll owe taxes on the amount in the IRA that they’ve earned over the years in capital gains. Given the size of the IRA, they can expect to pay around 37% in state and federal income taxes on their conversion. As a result, they’ll have about $630,000 to reinvest after they convert.
Post-withdrawal reinvestment: to help with an apples-to-apples comparison, we’ll assume that Louis and Maria’s children reinvest their inheritance after it comes out of the IRA. If they continue to get 7% returns per year (and take occasional distributions to cover expenses), then after another 20 years — 30 years after Louis and Maria pass away — they’ll end up with $7.18 million in their pockets over the years, after they pay the capital gains taxes on all of the earnings they built up after they drained the IRA
Learn more about legal matters for children here.
Option 3: Do Nothing
If, instead, Louis and Maria do nothing — they don’t convert their IRA to a Roth and they don’t set up a trust — their children will be far behind at the end of the day. Assuming the same 6% growth in Louis and Maria’s final years, 7% growth once the kids take possession of the IRA, and occasional withdrawals to cover expenses, the initial $1 million IRA would grow to $2.39 million by the time Louis and Maria pass away and, due to the punitive taxes associated with an IRA transfer, just $2.85 million after 30 years.
What we offer:
Want to know more on how to manage your capital gains? Check out our ultimate Charitable Remainder Trust guide. Use our our calculator to evaluate the potential return on investment given your situation. And if you have any questions, contact us through our chat button below, or schedule a meeting!
We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy.