Holiday gift tax planning for IRAs

The big tax benefits come in the way gifts can be used in conjunction with retirement accounts.

Individual retirement accounts cannot be gifted during the owner’s lifetime. Once funds are withdrawn from an IRA, they are generally taxable. But funds outside of IRAs can be used to beef up retirement savings for children, grandchildren, and even parents, and can be done free of gift tax. Gifting can also save family income taxes on Roth IRA conversions.

ANNUAL EXCLUSION GIFTS

For 2023, anyone can give up to $17,000 to any other person. There are no limits on the number of people you can make gifts to under this provision. These gifts are not only tax-free, but they don’t count toward the estate/gift tax exemption, which for 2023 is $12.92 million per person, or $25.84 million for a married couple.

Often when people are planning family gifts at year-end, they think they’re limited to the annual exclusion amount. But gifts above the annual exclusion amount still aren’t taxable until they exceed the generous estate/gift tax exemption amounts. This means the $12.92 million/$25.84 million exemption amounts can also be used for lifetime gifting in ways that expand the funds available for retirement tax planning.

Gifting has several tax benefits:
• The gift reduces the estate value by removing the property from the estate.
• The gift removes the income the property would have generated, lowering current and future income taxes.
• The gift removes the appreciation on the property from the estate.
• The gift is tax-free to the recipient.

For this discussion of gifting, I am referring to cash gifts, not highly appreciated property, which can qualify for a step-up in basis after death. The step-up in basis eliminates the capital gain on the lifetime appreciation when received by the beneficiary.

Those are the gifting basics, but the big tax benefits are in how these gifts can be used in conjunction with retirement accounts.

ROTH IRA CONTRIBUTIONS

Parents and grandparents can gift children (or anyone else) funds to make annual IRA or Roth IRA contributions. The 2023 IRA contribution limit is $6,500 ($7,500 if age 50 or over), which is well below the annual gift exclusion amount. That would make a nice stocking stuffer.

ROTH CONVERSIONS

Gifts can also be made to children, grandchildren, or anyone else to pay the tax on their Roth conversions.

Our current low tax rates can allow great leverage with these gifts. For example, a gift of the $17,000 annual exclusion amount (for 2023) can allow a child to convert $77,273 to a Roth IRA at the 22% marginal rate ($77,273 x 22% = $17,000). Even more can be converted for someone in a lower tax bracket. Even at the 24% marginal rate, that $17,000 can convert $70,833 ($70,833 x 24% = $17,000). (Of course, any state income taxes would also have to be considered here.) That’s big bang for the buck. Grandparents in particular love this, knowing that their gift will have an immediate return and will help provide a big boost to a grandchild’s Roth retirement savings.

Remember that a gift for this purpose isn’t limited to the annual exclusion amount. Gifts beyond that amount can be made, with the only downside being that they will cut into the very high lifetime exemption. Larger gifts can create much larger Roth conversions, although the higher the child’s tax rate, the less can be converted using the gifted funds.

This gifting strategy can work particularly well for adult children who have much larger IRAs that can be either completely or partially converted. While the gifts are tax-free, remember that the larger the conversion, the larger the tax bill. Tax planning for the child should thus take their projected tax rates into account.

GIFTING UP THE FAMILY TREE

Normally, estate planning involves parents or grandparents making gifts to children or grandchildren to reduce the parent or grandparent’s estates. But good retirement tax planning can also be done by reversing the process and gifting up the family tree. This can be very helpful for IRA beneficiaries, since inherited IRAs can’t be converted to inherited Roth IRAs, leaving beneficiaries stuck with taxable inherited IRAs just when they might be in their own highest earnings years.

Say Jane is in a high tax bracket and is the beneficiary of her mother’s $500,000 IRA. Mom is taking large taxable required minimum distributions each year. Mom has other funds and doesn’t need her IRA money, but takes annual RMDs because she must. When Jane inherits Mom’s IRA, she will likely be subject to the 10-year rule, so all those inherited IRA funds will have to be withdrawn and taxed by the end of the tenth year after death. At Jane’s projected tax rate, that could erode a good portion of the inherited IRA, especially if (as is likely) future tax rates increase. And Jane wouldn’t have the option of converting the inherited IRA.

Let’s change the tax equation by having Jane give Mom enough to convert Mom’s entire IRA to a Roth IRA. Even if that pushes Mom into a higher tax bracket, say 37%, a gift of $185,000 would be enough to pay the conversion tax ($500,000 x 37% = $185,000). (Again, any state income taxes would also have to be considered.) Of course, the tax bill (and the required gift) would be less if Mom is in a lower bracket. Even if Mom’s bracket is high, the tax bill could be reduced a bit if Mom does a series of smaller annual Roth conversions to have the entire IRA converted over a few years.

The benefit to Mom is that she gets a free Roth conversion, and is no longer subject to annual RMDs, so her tax bill will be lower each year. She doesn’t need the funds, and now that they’re in her Roth IRA, they can continue to grow income-tax-free for the rest of her life, and 10 years beyond to Jane.

The benefit to Jane is that now she will inherit a tax-free Roth IRA with all that accumulation, and the tax was paid at Mom’s lower tax rate (compared to what Jane’s rate might be in the future). When Mom dies, Jane is still subject to the 10-year rule, but the Roth IRA distribution to her at that time will be income-tax-free. In addition, since Jane has inherited a Roth IRA, there are no annual RMDs required for years one through nine of the 10-year term. Of course, remember to make sure that Mom names Jane as her Roth IRA beneficiary!

Find out the reasons to name a trust as IRA beneficiary

Now go one better: Even though Mom’s IRA will be income-tax-free to Jane, based on future estate exemption levels, Jane may be in a taxable estate tax situation, and the inherited Roth will be included in her estate. For that reason, Jane may not want to inherit Mom’s IRA.

In that case, have Mom name her grandchildren (Jane’s children) as her Roth IRA beneficiaries, bypassing Jane’s estate completely.

These outcomes can all flow from gifts made now under the generous gift tax levels. This kind of tax planning can spread holiday cheer for decades!

Happy holidays to all.

For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop, please visit www.IRAhelp.com.