So far in our series on gifting an IRA, we’ve explained the state of the law, identified key decision points, and pointed out some of the tradeoffs between the two most popular strategies: using a Charitable Remainder Trust and converting to a Roth IRA to mitigate the tax consequences of the gift. In this post, we’ll dive through a case study to pinpoint the differences between those two approaches.
A quick refresher
$30 trillion will pass from Baby Boomers to Millennials over the next decade — double the size of the entire U.S. economy. Unfortunately, the best approach to tax-efficient giving, the Stretch IRA, is no longer available as a result of the 2020 SECURE Act. Now, beneficiaries other than your spouse — kids and grandkids, for example — have to withdraw all inherited IRA assets within 10 years of the IRA owner's death (or pay a 50% penalty), and, critically, those forced distributions are taxed at ordinary income tax rates instead of the lower capital gains rates.
So what to do? Now that the Stretch IRA is a thing of the past, two strategies have risen to the top of the heap of potential replacements: Roth conversions and Charitable Remainder Trusts (CRTs). With a Roth conversion, you can pay the taxes on your IRA gains today, thereby eliminating the tax burden on their heirs. With a CRT, your assets can grow on a pre-tax basis and your beneficiaries can defer their tax bill for as long as possible. Both strategies can help you earn 90% more from a gifted or inherited IRA than if you had done no planning.
Now on to an example where we compare the impact of all three strategies.
Louis and Maria and their children
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.
- IRA with $1 million in cumulative earnings as of today
- IRA is expected to pass onto heirs in 15 years after both Louis and Maria passed away
- IRA investments will earn 6% annual returns, after required minimum distributions, during that time and for the ten years after the account passes to Louis and Maria’s children.
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.
Pre-gift growth. Because they don’t need the money, that $630,000 will grow until Louis and Maria pass away. There will be some required minimum distributions (RMDs) to account for, but it’s sufficient for our purposes to assume that the account will grow 6% per year after those RMDs come out. If that happens, the account will be worth almost exactly $1.5 million in 15 years, when it passes to their children.
10-year growth and withdrawals. By the current rules of IRA inheritance, the kids will have 10 years to withdraw all of the IRA money. Assuming that they can get 7% returns per year — maybe they dial up the risk, or the market has a good decade — that $1.5 million would just about double, to $2.81 million. At the end of that 10-year period, Louis and Maria’s children would be required to withdraw the money, but those withdrawals would be tax-free because Louis and Maria paid the tax upfront when they did their Roth conversion.
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.
Instead of passing the IRA assets directly to their children, Louis and Maria could pass them to a Charitable Remainder Trust of which the kids are beneficiaries. That trust, in turn, can run for as long as the kids’ entire lives.
How would this help? A CRUT is a tax-exempt account much like an IRA, so Louis and Maria will pay no taxes today, and, critically, neither they nor their kids will pay taxes when the IRA changes hands. In short, an IRA-to-CRUT rollover can prolong the tax-exempt nature of the account for as long as the heirs’ lifetimes.
Let’s take a look at the math.
Current value and growth. Assuming, as before, that Louis and Maria’s IRA is currently worth $1 million and that they get 6% returns for the next 15 years, the account will be worth about $2.39 million when they pass away — they’re about $900,000 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 the same 30-year period.
Liquidity. Although CRUTs are more flexible with respect to distributions than many irrevocable trusts, you won’t have access to the entire value of the trust in any given year; withdrawals are capped by the IRS at somewhere between 5% and 50% of the value, depending on the type of trust you choose, but typical rates are between 5% and 15%. Let’s say Louis and Maria set up a trust that is set to receive 7% annual distributions. The children would be entitled to 7% of $2.39 million, or about $168,000, in the first year, and another 7% every year for the remainder of the trust’s term.
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.
Which to choose?
It’s clear, then, that the family should do some sort of planning for the IRA assets they plan to pass on. But should it be a Roth Conversion or a trust? As we explained last time, the tradeoffs between the CRUT and the Roth Conversion approaches are relatively straightforward:
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 tradeoffs for that simplicity are (1) you have to act soon since a Roth conversion will typically make sense only if you expect to live another 15 years or more; and (2) 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.
Charitable Remainder Trust Rollover: A Charitable Remainder Trust, by contrast, is a much more flexible option. There’s no commitment today and no real cost to getting set up. 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
- You and your heirs do not 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:
- Anyone who is using their IRA for living expenses.
- Looking to minimize their expenses now and preserve future financial flexibility.
- May have health issues or are uncertain about how long they may live.