Using a Charitable Remainder Trust in place of a Stretch IRA can help you pass assets to loved ones and defer the taxes they would pay on distributions.
Highlights
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 effectively pass on those assets. Today, we’ll be examining how parents can pass on their IRA assets to the next generation in a tax-efficient way.
Historically, one of the most powerful ways for tax planning between generations was for parents to pass on their IRA to their children — without liquidating the assets inside or paying any transfer taxes — via a “Stretch IRA.” With that arrangement, 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-deferred, just as they had been doing when the parent held them. That way, the assets could continue to grow tax-free until the children were 59.5 when they would be required to start taking distributions.
As a result of the 2020 SECURE Act, however, those rules changed, with two major implications.
As an example, imagine that Sophia’s parents died in 2020, and Sophia, a San Francisco resident, inherited a $1 million IRA that will grow 9% annually for the next 10 years before she is forced to withdraw it all. In 10 years, the IRA will be worth $2.4 million. That’s great! But when Sophia withdraws that money, she will owe ~$1.2 million in taxes (a 50% tax rate!), and she’ll keep only $1.2 million. Keeping only half of the assets is a significant step back.
But what if Sophia could keep those assets growing — and keep deferring the taxes — for longer than 10 years, or even for the rest of her life? That kind of tax magic is possible with a Charitable Remainder Trust.
Before we go into the strategy, though, here’s a quick refresher on why tax deferral is so powerful.
Why does tax deferral matter?
Deferring taxes is one of the best ways Americans have to improve on the already significant impact of an investment’s compound growth. And people have noticed: The first advice most people get when they join the workforce is to max out their contributions to their IRAs and, if available, their 401(k)s.
Why are tax-deferred accounts such a big deal? Because they protect your income from up-front taxes, and you get to reinvest and grow the tax savings. For example, if you are a California resident and you have long-term capital gains of $1 million when your company goes public, you would typically pay about $360,000, or 36%, in taxes, and you would be left with about $640,000 to invest (or spend!) going forward. With the use of a tax-deferred trust, by contrast, you could keep the whole $1 million to reinvest.
And think about what happens when you put those savings in the stock market, crypto, or angel investments: your tax savings continue to grow. While it seems obvious that you would rather have $1 million in the market working for you than $640,000, most people don’t appreciate how big of a difference that will make over time. Assuming just a 9% annual return—the average historical return from relatively conservative index investing—that extra $340,000 could turn into more than $1.9 million over 20 years. That’s the magic of the one-two punch of tax deferral and compounding.
How you can grow your IRA inheritance tax-free for more than 10 years
That’s all well and good, but we just told you that long-term tax deferral through IRA inheritance is no longer available as a result of legal changes. So what can you do?
Let’s check back in with Sophia and her family. Instead of passing the IRA assets directly to Sophia, her parents could pass them to a Charitable Remainder Trust (also known as a CRT or CRUT — read our guide here) of which Sophie is a beneficiary. That trust, in turn, can run for as long as Sophia’s entire life.
How would this help? A CRT is a tax-exempt account much like an IRA, so Sophie’s parents’ assets can continue to grow on a tax-free basis as long as they are in the trust, potentially creating 47% more growth for Sophie over her lifetime.
Comparing the numbers
Let’s assume Sophia and her parents are looking at a version of a Charitable Remainder Trust called a NIMCRUT — the most common choice among our customers — and break down how much she could save with and without a trust using the same assumptions of a 9% annual growth rate and tax code.
10-Year IRA Rollover
After the forced sale in year 10, Sophie would keep roughly half of the $2.4 million in value that has accumulated in the IRA — $1.2 million after taxes. (Recall that the tax bill is so steep because these inherited IRA distributions are taxed as ordinary income.)
Sophia reinvests that $1.2 million. Assuming she lives until 2062 — her expected lifetime according to the Social Security Administration — then at the end of her life Sophia would have accumulated $13.8 million after taxes.
What about those taxes? The rules of IRAs dictate that Sophia would pay ordinary income tax rates on the entire amount distributed from the IRA at the 10-year mark — the $2.4 million — but then would pay long-term capital gains rates on further earnings.
CRT for Life
If Sophia’s parents’ IRA fund instead went into a CRUT upon their passing (and assuming Sophia didn’t touch the money for the rest of her life), she would have $20 million after taxes.
Looking at the taxes again, Sophie would pay ordinary income taxes on the first $1 million that is distributed from the CRUT and then shift to paying long term capital gains
What is the benefit of the CRUT, then? Critically, by deferring those income taxes for an additional 30 years, Sophie can create significantly more wealth. She’ll pay only $1 million in ordinary income taxes (instead of $1.3 million) and, importantly, she’ll get to defer those taxes until the end of her life. As a result, Sophie will get to reinvest an additional $1.8 million compared to the plain vanilla IRA, and she’ll end up with a total of $20 million in the end.
How CRUTs Can Supercharge An IRA Inheritance
We’ve given you the big picture. Getting tactical for a moment, let’s take a look at the specific mechanics of Sophie’s savings. By using a version of a Charitable Remainder Trust called a NIMCRUT that runs for her life, Sophia would get a number of benefits:
Highlights
- With the loss of Stretch IRAs in 2020, Charitable Remainder Trusts have become a great alternative for parents to efficiently pass their IRA assets on to their children
- Using a Charitable Remainder Trust enables an IRA beneficiary to defer the ordinary income taxes they would pay on distributions for many years and create more wealth
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 effectively pass on those assets. Today, we’ll be examining how parents can pass on their IRA assets to the next generation in a tax-efficient way.
Historically, one of the most powerful ways for tax planning between generations was for parents to pass on their IRA to their children — without liquidating the assets inside or paying any transfer taxes — via a “Stretch IRA.” With that arrangement, 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-deferred, just as they had been doing when the parent held them. That way, the assets could continue to grow tax-free until the children were 59.5 when they would be required to start taking distributions.
As a result of the 2020 SECURE Act, however, those rules changed, with two major implications.
- Beneficiaries other than your spouse — kids and grandkids, for example — now have to withdraw all inherited IRA assets within 10 years of the IRA owner's death (or pay a 50% penalty).
- Those forced distributions are taxed at ordinary income tax rates instead of lower capital gains rates.
As an example, imagine that Sophia’s parents died in 2020, and Sophia, a San Francisco resident, inherited a $1 million IRA that will grow 9% annually for the next 10 years before she is forced to withdraw it all. In 10 years, the IRA will be worth $2.4 million. That’s great! But when Sophia withdraws that money, she will owe ~$1.2 million in taxes (a 50% tax rate!), and she’ll keep only $1.2 million. Keeping only half of the assets is a significant step back.
But what if Sophia could keep those assets growing — and keep deferring the taxes — for longer than 10 years, or even for the rest of her life? That kind of tax magic is possible with a Charitable Remainder Trust.
Before we go into the strategy, though, here’s a quick refresher on why tax deferral is so powerful.
Why does tax deferral matter?
Deferring taxes is one of the best ways Americans have to improve on the already significant impact of an investment’s compound growth. And people have noticed: The first advice most people get when they join the workforce is to max out their contributions to their IRAs and, if available, their 401(k)s.
Why are tax-deferred accounts such a big deal? Because they protect your income from up-front taxes, and you get to reinvest and grow the tax savings. For example, if you are a California resident and you have long-term capital gains of $1 million when your company goes public, you would typically pay about $360,000, or 36%, in taxes, and you would be left with about $640,000 to invest (or spend!) going forward. With the use of a tax-deferred trust, by contrast, you could keep the whole $1 million to reinvest.
And think about what happens when you put those savings in the stock market, crypto, or angel investments: your tax savings continue to grow. While it seems obvious that you would rather have $1 million in the market working for you than $640,000, most people don’t appreciate how big of a difference that will make over time. Assuming just a 9% annual return—the average historical return from relatively conservative index investing—that extra $340,000 could turn into more than $1.9 million over 20 years. That’s the magic of the one-two punch of tax deferral and compounding.
How you can grow your IRA inheritance tax-free for more than 10 years
That’s all well and good, but we just told you that long-term tax deferral through IRA inheritance is no longer available as a result of legal changes. So what can you do?
Let’s check back in with Sophia and her family. Instead of passing the IRA assets directly to Sophia, her parents could pass them to a Charitable Remainder Trust (also known as a CRT or CRUT — read our guide here) of which Sophie is a beneficiary. That trust, in turn, can run for as long as Sophia’s entire life.
How would this help? A CRT is a tax-exempt account much like an IRA, so Sophie’s parents’ assets can continue to grow on a tax-free basis as long as they are in the trust, potentially creating 47% more growth for Sophie over her lifetime.
Comparing the numbers
Let’s assume Sophia and her parents are looking at a version of a Charitable Remainder Trust called a NIMCRUT — the most common choice among our customers — and break down how much she could save with and without a trust using the same assumptions of a 9% annual growth rate and tax code.
10-Year IRA Rollover
After the forced sale in year 10, Sophie would keep roughly half of the $2.4 million in value that has accumulated in the IRA — $1.2 million after taxes. (Recall that the tax bill is so steep because these inherited IRA distributions are taxed as ordinary income.)
Sophia reinvests that $1.2 million. Assuming she lives until 2062 — her expected lifetime according to the Social Security Administration — then at the end of her life Sophia would have accumulated $13.8 million after taxes.
What about those taxes? The rules of IRAs dictate that Sophia would pay ordinary income tax rates on the entire amount distributed from the IRA at the 10-year mark — the $2.4 million — but then would pay long-term capital gains rates on further earnings.
CRT for Life
If Sophia’s parents’ IRA fund instead went into a CRUT upon their passing (and assuming Sophia didn’t touch the money for the rest of her life), she would have $20 million after taxes.
Looking at the taxes again, Sophie would pay ordinary income taxes on the first $1 million that is distributed from the CRUT and then shift to paying long term capital gains
What is the benefit of the CRUT, then? Critically, by deferring those income taxes for an additional 30 years, Sophie can create significantly more wealth. She’ll pay only $1 million in ordinary income taxes (instead of $1.3 million) and, importantly, she’ll get to defer those taxes until the end of her life. As a result, Sophie will get to reinvest an additional $1.8 million compared to the plain vanilla IRA, and she’ll end up with a total of $20 million in the end.
How CRUTs Can Supercharge An IRA Inheritance
We’ve given you the big picture. Getting tactical for a moment, let’s take a look at the specific mechanics of Sophie’s savings. By using a version of a Charitable Remainder Trust called a NIMCRUT that runs for her life, Sophia would get a number of benefits:
- Their assets can grow tax-free for life while in the trust, instead of just for 10 years, potentially creating 47% or more wealth.
- Sophia can limit the amount of gains on which she pays the higher ordinary income tax rates, keeping a greater amount of her parents’ hard-earned money for her and her family’s benefit.
- Sophia can control when she takes distributions by controlling when the trust realizes income. The assets are protected and stay out of the reach of creditors while in the trust
- Unless the next generation needs the IRA inheritance liquid soon after receiving it, moving the assets to a Charitable Remainder Trust can be a great way to build wealth and efficiently pass the assets to future generations.
RSS Feed
