ROTH IRA + IRA TRUST: Tax free growth/income and asset protection for your heirs

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Most clients like the idea of tax-free growth, tax-free income, asset protection, and maintaining some level of control over assets after they are passed to future generations.  Maximizing Roth IRA growth during a client’s lifetime and leaving the Roth IRA to an “IRA Trust” (aka, “Legacy Trust,” “Retirement Account Trust,” etc.) at the client’s death provides a one-two punch with incredible long-term benefits.

Legislative developments over the past few years have resulted in a tax environment in which income tax rates have increased, yet concerns over future federal estate tax have been minimized (due to high estate tax exemption amounts and the current political climate).  In addition, the introduction of a new 3.8 percent Medicare surtax on “passive income” (e.g. dividends, interest, capital gain, etc.) has further increased the attractiveness of tax-favored investment vehicles, especially for high-earners and their families.

In addition, the continued liberalization of Roth IRA rules by Congress has lead to big opportunities for long-term tax-favored planning.  These recent changes include, but are not limited to: (1) unlimited ability to convert some or all of an accountholder’s pre-tax IRA funds to a post-tax Roth IRA, regardless of the accountholder’s personal income, as long as the accountholder is willing to pay the income tax that results from the conversion; and (2) “in-plan” Roth conversions within qualified retirement plans (e.g. 401(k), 403(b), 457), regardless of the plan participant’s age and employment status (i.e., as of January 2013, a participant no longer must be 59 ½ years of age or “separated from service” in order to take advantage of Roth conversions within qualified plans).

Increasingly, savvy clients are creating large pools of assets within Roth IRA accounts, often by executing small Roth conversions each year.  In theory, these Roth IRAs would be used during the client’s retirement years as income replacement.  However, if instead, these Roth IRA accounts are viewed as wealth transfer devices, the tax benefits afforded to these accounts grow exponentially.  There are several reasons why this is the case:

(1)   Aggressive investment strategy. If a Roth IRA is invested with the pre-planned intention that the account will be for the benefit of the client’s children (or grandchildren), the account can invested with a high-risk / high-return strategy that will, on average, result in greater long-term growth.

(2)   Long term growth.  If the client can ensure that future generations will not spoil the plan by taking large Roth IRA distributions after the client’s death, tax-free growth (and, eventually, tax-free income) can be enjoyed for 50+ years.  This can be done by naming an IRA Trust on the Roth IRA’s beneficiary designation form and allowing the trust to restrict distributions to the ultimate beneficiaries after the client’s death.  However, the trust must be very carefully drafted to ensure compliance with the complex IRA distribution rules, which is why it is generally recommended that the IRA Trust be a standalone instrument, not simply part of the client’s current Revocable Trust and/or other estate planning structure [note: if a “standard” Revocable Trust is named as the beneficiary of a retirement account and the wording of the trust is not done correctly, the ultimate beneficiaries (e.g., children) might be forced to withdraw the funds very quickly after the original accountholder’s death – which would minimize tax-free growth and increase the likelihood that the beneficiary would receive more funds than they need and/or can emotionally handle properly).

A simplified client example can show the power of this Roth IRA + IRA Trust concept.  Consider two buckets of money, both initially worth $200,000, but one in a taxable brokerage account (i.e. the client’s personal funds) and one in a Roth IRA.  Further, assume the following:

(1)   The client is 45 years old, has two children that are 15 years old (twins), and the earnings in both accounts are reinvested for the next 50 years.

(2)   Both accounts are invested in the exact same manner and grow an average of 8-percent per year (note: in reality, the Roth IRA could be invested more aggressively because current tax consequences are generally not a concern, leading to more investment options and opportunities).

(3)   The earnings in the taxable account are subject to an average tax rate of 20-percent, both during the client’s life and in the hands of the client’s children (note: this assumes that most of the earnings within the account are long-term capital gain, rather than interest and dividends, which would be taxed as ordinary income rates).

(4)   The client dies at age 75 (children are 45) and neither account is subject to estate tax – because the client’s estate is below the applicable estate tax exemption.

(5)   The taxable account passes to the client’s children equally (i.e., moves into their individual names) and the Roth IRA passes to an IRA Trust.  The IRA Trust then pays out “required minimum distributions” to the children during their lifetimes (i.e., one distribution to each child per year), as required by the federal law.

(6) The children continue to invest the brokerage account (i.e., non-retirement funds) and the IRA Trust continues to invest the Roth IRA funds going forward (i.e., despite the client’s death, the funds continue to be invested in the same manner as before).

After 50 years (when the client’s children are 65 years old; 20 years after the client’s death), the taxable account will have grown to approximately $4.4 million (after taxes), but will have provided no current cash benefit to the client’s children, due to the re-investment of earnings.  Of course, in the real world the client’s children likely would have used at least some of the income and/or principal of the account, thereby greatly reducing the accounts value.  The Roth IRA, controlled by the IRA Trust, would have grown to approximately $5 million, but, more importantly, the distributions after the client’s death would have resulted in average yearly tax-free income to the client’s children of $128,000 (or $2.56 million total).

Taking the example one step further, the Roth IRA will continue minimum distributions for 20 more years (from when the client’s children are 65 to 85 years old) and the average yearly tax-free distribution will be over $350,000.  The end result is a very nice supplement to the client’s children’s retirement income, and all under the watchful eye of the IRA Trust’s trustee. In this way, a Roth IRA can be viewed not as a “retirement account” for the original accountholder, but rather a retirement account for the accountholder’s children!

In summary, although the intended purpose of an IRA is to replace income during the accountholder’s retirement years, viewing these accounts in such a limited light results in a huge missed opportunity for overall capital accumulation, asset protection, and, most importantly, wealth transfer to future generations.