You can create significant returns by passing on your IRA to your kids via a Charitable Remainder Trust or a Roth conversion.
Which option is better depends on whether you are using your IRA for living expenses, how long you expect to live, and how important financial flexibility is to you.
Now that the Stretch IRA is a thing of the past — those who inherit an IRA can no longer spread their withdrawals over many years — there has been a rush to anoint the next best thing. For some, that will be to do a Roth Conversion today, thereby eliminating the tax burden on their heirs. For others, rolling over there IRA into a trust will to allow their assets to grow on a pre-tax basis and defer their tax bill for as long as possible. In most cases, though, some advance planning will be necessary.
In this post, we’ll compare these approaches, identify a few tradeoffs, and help you identify the right strategy for you.
Why do tax planning in advance for an IRA gift?
The case for doing something is self-evident if you plan to pass on your IRA assets to future generations, in most cases the additional return from using either of these options is above 50%. If you don’t plan ahead for gifting your IRA on to your loved ones when you pass away, they will be hit with both mandatory distributions and significant ordinary income taxes on all distributions, each equally painful in their own right.
With respect to mandatory distributions, they’ll be required to withdraw all of the gifted funds within 10 years. This forced distribution schedule will significantly hinder the prospects for asset growth since the number one way to achieve growth is by leaving your money to grow untouched by taxes and taking advantage of pre-tax compounding.
Even worse, when your loved ones make those mandatory withdrawals, they’ll owe the highest tax rates — state and federal ordinary income tax rates, which can total 50% or more — on every dollar they withdraw. These high tax rates can mean that your heirs can end up with less than half of the assets you intended to leave behind.
Faced with those costs, it makes sense for most people to do what they can to reduce the withdrawal tax rate and/or delay those mandatory distributions. But how?
The tax-advantaged options: Roth or Charitable Remainder Trust (CRUT)?
For most people, there are two leaders in the clubhouse when it comes to tax-advantaged planning for an IRA gift: Doing an immediate Roth conversion or setting up a Charitable Remainder Trust that will hold the assets when you pass away.
Why convert a standard IRA to a Roth?
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 upfront — 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 — the key benefit of a Roth account — in the future assuming the account has been open at least five years.
The benefits are clear for those looking to pass their IRA assets on to their children or other heirs (and not use yourself): By front-loading the taxes, you are freeing your loved ones of the significant tax burden that would accompany their inheritance when you pass away. However, your beneficiaries will in most cases have to withdraw the funds within 10 years. But 10 years of tax-free growth is better — for reasons that should be obvious — than tax-burdened growth over the same period.
Why roll an IRA into a Charitable Remainder Trust?
As we have explained elsewhere, another common strategy that can supercharge the tax-deferral benefits of the traditional IRA without imposing that significant tax burden on your family when they receive your IRA is to use a Charitable Remainder Trust (CRT). With a CRT, you can help your heirs extend the ten-year mandatory withdrawal schedule for as long as their entire lives and defer the harsh ordinary-income-tax bill that would otherwise apply after inheritance.
The benefits of the CRT strategy are many:
- The assets can grow tax-free in the CRT for as long as the person who inherits the IRA is alive, instead of just for 10 years.
- Your heirs can limit the amount of gains on which they pay higher ordinary income tax rates, lowering the effective tax rate on distributions and keeping a greater amount of your hard-earned money for your family’s benefit.
- Your heirs can control when they take distributions by controlling when the trust realizes income.
- The assets are protected and stay out of the reach of creditors while in the trust.
What are the tradeoffs between these strategies?
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.
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 are 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.
Which approach is right for you?
With those benefits and tradeoffs in mind, when might each strategy make sense?
Roth conversion. Because it involves an up-front cost and is irreversible, a Roth conversion can typically make sense for people who:
- Expect to live 15+ years
- Can afford the up-front tax bill
- Don’t need the IRA money to cover living expenses today or need a lot of financial flexibility
Charitable Remainder Trust: Because it preserves your optionality and involves no up-front costs or tax bill, an IRA-to-CRUT rollover can be a fit for people: - Who is using their IRA for living expenses - Looking to minimize their expenses now and preserve and future financial flexibility - May have health issues or uncertain on how long they may live.