With the diverse array of estate planning tools that advisors have in their arsenals today, it might be easy to overlook one relatively simple, tax-advantaged way to pass wealth to the next generation — individual retirement accounts. Your clients can fund IRAs or Roth IRAs for the benefit of their children and grandchildren, offering future benefits that can be even more substantial than those realized through funding their own retirement accounts. The simplicity of this strategy should not be taken for granted; however, there are important funding rules that apply once your client has chosen to use a retirement account as a wealth transfer tool.
Why use an IRA strategy?
All clients have heard of using IRAs and Roth IRAs to provide for their own eventual retirement income, but it is likely that many have never thought of using these accounts to pass wealth to their children and grandchildren. Not only can this strategy allow the client to transfer wealth to future generations, but it sets the child up with a retirement account so that the child might be encouraged to continue saving even after the client has stopped funding the account.
Roth IRAs are a particularly good option for clients looking to fund a child or grandchild’s retirement account — a $1,000 per year contribution, even if made for only three years, can grow to over $39,000 in forty-five years (assuming a six percent annual return). If the taxes are paid up front, as they are with a Roth IRA, all of this growth is taken tax-free when the child is finally ready to retire. Because we have no way of knowing what the tax rates will be forty-five years from now, eventual tax-free withdrawals can be extremely beneficial.
Contributions to a traditional IRA would, of course, be tax-deductible for the child, but because it is unlikely that the child has substantial earned income, the deduction would not be worth as much as it might be to an adult.
Further, with a Roth, the child can withdraw the contributions to the account tax-free without penalty at any time. Any earnings withdrawn before the child is otherwise eligible to withdraw the funds will be taxed (and subject to a 10 percent penalty), but the ability to withdraw contributions can provide added flexibility that is even more valuable considering the time period that must elapse before the child is eligible to make withdrawals.
The rules for establishing an IRA or Roth IRA for a child are similar to those that an adult must follow. First, there are limits on how much can be contributed each year: For 2013, the limit is $5,500.
Importantly, in order to contribute to an IRA or Roth IRA established in a child’s name, that child must have earned income for the year. The contributions to the child’s account cannot exceed the amount that the child earned during the year. Earned income does not include income that the child receives from investments, so the child must actually be working for the income to count. For clients whose children have part-time jobs, the client himself can contribute the amount that the child earns working in that job (up to the $5,500 limit in 2013).
As mentioned, any earnings that are withdrawn from a Roth (or any withdrawals from a traditional IRA) before the child turns 59½ will be taxed at ordinary income tax rates and are subject to a 10 percent penalty tax. However, the penalty does not apply if the child uses the funds to pay for qualified education expenses, so the IRA or Roth can also function as a type of emergency college savings account.
This nontraditional use of individual retirement accounts can provide your clients with a tax-preferred strategy for transferring wealth to their children and grandchildren. While this is important, using an IRA or Roth account in this manner also sets up these younger generations for future retirement savings long after their parents and grandparents have stopped contributing funds on their account.
For previous coverage of strategies for passing wealth to future generations in Advisor’s Journal, see How to Protect Your Child from a Financial Windfall: The $5.25 Million Question.