Paul O. Dillon, Attorney at Law

Should You Gift Kids Inheritance Now, or After You’ve Passed?

This is a genuine dilemma facing millions of parents and grandparents as they prepare to pass an enormous amount of wealth—$73 trillion—to the next generation. There are pros and cons to both approaches, according to the article, “Give the Kids Their Inheritance Now or Make Them Wait? 3 Things to Keep in Mind,” from Barron’s.

Giving too much too early could put parents in an economic bind in their later years. Therefore, this needs to be considered in light of today’s longer life spans. However, if you can afford to make a generous gift and your children could use the money now for a good purpose, it’s hard to justify making them wait.

How much to give is as critical as when to make the gift. The predominant concern is if you give your children too much, they won’t be motivated to earn their own wealth, or other family members will resent the gift. Estate planning attorneys and financial advisors routinely speak with families about these issues. These conversations always consider the values they want to instill in their children.

In some cases, parental support can help a child while working at an entry-level (i.e., low paying) job in their dream career. Covering the cost of rent for a few years can offer young adults a support net until they achieve financial stability.

This is very different than paying the expenses of a young adult with no career goal whose primary focus is a robust social life.

Anyone can make a yearly gift to any other person of up to $17,000 tax-free, or $34,000 per couple, but there are ways to make gifts without triggering gift taxes. Direct tuition payments to schools are tax-free. Unlike putting money into a 529 account, there is no limit to how much can be paid directly to a college or university. Parents and grandparents could also help with a downpayment on a child’s home without paying gift taxes.

Gifts don’t have to be large to have an impact. Some parents and grandparents give their children or grandchildren a small amount to start saving for retirement. A gift of a few thousand dollars during their 20s can grow into a nice sum over many decades. If the recipient has earned income, you can contribute to their IRA or Roth IRA accounts.

If assets are limited, consider giving personal possessions, such as jewelry or family heirlooms, to younger generations. You’ll get to see them enjoy their gifts, without putting your own financial situation at risk.

Whenever the decision is made to make these gifts, families should talk about their values and intentions around money.

If there are concerns about children losing an incentive to work because of the family’s wealth, a spendthrift trust might pass wealth along while controlling its distribution.

Remember that today’s generous federal estate tax rules are set to expire in 2026. Currently, individuals can gift up to about $13 million ($26 million for couples) tax-free in their estate plans. If the exemptions expire, this amount will be cut by approximately half.

Reference: Barron’s (Nov. 4, 2023) “Give the Kids Their Inheritance Now or Make Them Wait? 3 Things to Keep in Mind”

A Roth Conversion Can Benefit Retirement Plan

Before 2020, leaving a traditional IRA to younger beneficiaries created dual tax breaks. The original owner reduced taxable income by making pretax contributions during their lifetime, and beneficiaries could stretch the benefits of tax deferral over their lifetime. All that ended with the SECURE Act, but there are some options, as explained in the article “Why a Roth Conversion is a Powerful Estate Planning Tool” from Think Advisor.

After the SECURE Act, beneficiaries who don’t qualify as “eligible designated beneficiaries” or EDBs must empty the inherited IRA account within ten years. If the original owner had already begun taking minimum required distributions, the beneficiary must also take annual RMDs during the ten-year distribution period.

Someone who inherits a traditional IRA must now pay taxes on the entire account balance within ten years of the original account owner’s death. This can be a sizable tax burden, especially if the beneficiary is in their peak earning years.

Roth beneficiaries who don’t qualify as EBDs must empty the account within the same ten-year distribution period applying to traditional IRA accounts. However, Roths have a decisive advantage during the original owner’s lifetime: no RMD rules.

The original owner will always be deemed to have died before their required beginning date because a Roth account can never go into pay status since there is no required beginning date for distributions. Therefore, the Roth IRA beneficiary can wait until the tenth year to empty the account, allowing the funds to grow tax-free without worrying about the tax hit in Year 10.

When the beneficiary eventually takes distributions, the original contributions are nontaxable because the original owner paid taxes on Roth contributions during their lifetime. If the five-year rule is satisfied—at least five years have passed since the original owner made their first contribution or conversion to the account—earnings will also be tax and penalty-free to beneficiaries.

Roth accounts benefit the original owner because they offer a tax-free source of income during retirement. However, they’re also a valuable tax-free gift for account beneficiaries.

Reference: Think Advisor (Sep. 1, 2023) “Why a Roth Conversion is a Powerful Estate Planning Tool”

Roth IRA has a 5-Year Rule

Roth IRAs are popular for their flexibility and the simplicity of putting after-tax dollars in and not paying taxes on withdrawals during retirement. However, making the most of a Roth IRA requires paying attention to the details, according to a recent article “What is the Roth IRA 5-Year Rule?” from U.S. News & World Report.

More specifically, there are certain five-year rules that can undo all the good that comes from using a Roth, if you don’t know them. Avoid paying penalties or fees, by understanding how the Roth IRA rules work.

The Roth IRA five-year rule applies to investment earnings, and not to initial contributions. If you make withdrawals of investment earnings before the five-year time period, you’ll get hit with taxes and penalties, no matter how old you are. Many people think that once they turn 65 or 70, they can tap their Roth IRA whenever they want, but that’s not true.

Once you’ve opened and funded a Roth IRA, you’ll have to wait five years until you can start taking tax-free withdrawals of your investment earnings. The clock starts ticking on the date you open the account and make your very first contribution.

After five years, there are still certain requirements that must be met to take out earnings without a penalty. Before you can take out tax-free withdrawals, you will need to be at least 59½ or older.

That’s even if your first contribution was made the year you celebrated your 58^th birthday. You’ll need to wait until age 63 before you may take qualified distributions from the account. The five-year rule applies, even if you opened the Roth IRA at age 70.

How is this time frame calculated? The IRS does it based on tax years. A tax year runs from January 1 to December 31. The deadline for contributions is the same as the deadline for filing taxes. Let’s say you funded a Roth IRA in April 2021 for the calendar year of 2020. The five-year rule begins on January 1, 2020. Apply the five-year rule, and you could begin taking withdrawals from the account on or after January 1, 2025.

What happens if you need to make withdrawals before the account hits that five-year mark? In that case, withdraw contributions to the account and not investment earnings.

If you’ve contributed money to a Roth IRA account, you can take that money out with no tax or penalty, no matter how old you are. However, make sure you meet all of the requirements. Remember that to avoid any taxes or penalties, you’ll need to leave the earnings in the account.

Reference: U.S. News & World Report (March 10, 2021) “What is the Roth IRA 5-Year Rule?”

Pay Raise can Have an Impact on Retirement Savings

Getting a raise is always good news, but if you are a Highly Compensated Employee (HCE), it could negatively impact your ability to save for retirement through your 401(k). There are some steps you can take, says the recent article “That raise you got might complicate saving for retirement, but advisors have workarounds” from CNBC.

The 2021 and 2020 limits for deductible contributions to a 401(k) plan are $19,500, or $26,000, if you are over 60 and eligible for a $6,500 catch-up option. If you qualify as an HCE, how much you may contribute to your 401(k), depends on the participation rates of other employees in the company. You are not allowed to contribute more than 2% above the average contributions of other employees in the plan.

Here is how it works. If the average employee contribution to a 401(k) plan is 5% of their salary, the HCE may not contribute more than 7% to their account. Someone earning $150,000 would be limited to a maximum of $10,500 to the plan. The rule was created to encourage wider participation in the retirement plan. There are also rules about the employer’s contributions to the plan to maintain its tax-qualification status.

For HCEs, this presents a problem. It is a good problem, but still a problem. Many tax analysts expect tax rates for HCEs to rise in the near future, so simply deferring taxes now might not be the entire solution.

Every dollar added to a qualified plan today saves about 37 cents in taxes. However, if the withdrawals are taxed at 42-45%, the tax-free growth advantage is minimized or lost entirely. What can you do?

• Contribute what you can to qualified plans, especially if your employer has a matching plan.
• If you are over 50, use the $6,500 catch-up contribution regardless of any limits on regular contributions.
• Use a traditional IRA or Roth IRA, if you are eligible to save $6,000 a year or $7,000 if you are over 50.

The Roth IRA is funded with after-tax dollars but grows tax-free and withdrawals are not taxed, a major reason for their appeal. However, most HCEs do not qualify for Roth IRAs, since the contribution limits phase out when a single taxpayer’s income tops $125,000 and are eliminated entirely at $140,000.

Another strategy is to use a non-deductible IRA that can eventually be rolled into a backdoor IRA. The account is funded with after-tax dollars, and the earnings are also taxable. However, account holders are allowed to roll the funds into a Roth IRA tax-free and with no penalty until 2025, regardless of their income level. The contribution limits are the same as with a traditional IRA.

Reference: CNBC (March 9, 2021) “That raise you got might complicate saving for retirement, but advisors have workarounds”

How Do I Talk to the Children about My Estate Planning?

Some $68 trillion will move between generations in the next two decades, reports U.S. News & World Report in the article “Discuss Your Estate Plan With Your Children.” Having this conversation with your adult children, especially if they are members of Generation X, could have a profound impact on the quality of your relationship and your legacy.

Staying on top of your estate plan and having candid discussions with your children will also have an impact on how much of your estate is consumed by estate taxes. The historically high federal exemptions are not going to last forever—even without any federal legislation, they sunset in 2025, which isn’t far away.

One of the purposes of your estate plan is to transfer money as you wish. What most people do is talk with an estate planning attorney to create an estate plan. They create trusts, naming their child as the trustee, or simple wills naming their child as the executor. Then, the parents drop the ball.

Talk with your children about the role of trustee and/or executor. Help them understand the responsibilities that these roles require and ask if they will be comfortable handling the decision making, as well as the money. Include the Power of Attorney role in your discussion.

What most parents refuse to discuss with their children is money, plain and simple. Children will be better equipped, if they know what financial institutions hold your accounts and are introduced to your estate planning attorney, CPA and financial advisor.

You might at some point forget about some investments, or the location of some accounts as you age. If your children have a working understanding of your finances, estate plan and your wishes, they will be able to get going and you will have spared them an estate scavenger hunt.

If possible, hold a family meeting with your advisors, so everyone is comfortable and up to speed.

Most adult children do not have the same experience with taxes as parents who have acquired wealth over their lifetimes. They may not understand the concepts of qualified and non-qualified accounts, step-up in cost basis, life insurance proceeds, or a probate asset versus a non-probate asset. It is critical that they understand how taxes impact estates and investments. By explaining things like tax-free distributions from a Roth IRA, for instance, you will increase the likelihood that your life savings aren’t battered by taxes.

Even if your adult children work in finance, do not assume they understand your investments, your tax-planning, or your estate. Even the smartest people make expensive mistakes, when handling family estates.

Having these discussions is another way to show your children that you care enough to set your own ego aside and are thinking about their future. It’s a way to connect not just about your money or your taxes, but about their futures. Knowing that you purchased a life insurance policy specifically to provide them with money for a home purchase, or to fund a grandchild’s college education, sends a clear message. Don’t miss the opportunity to share that with them, while you are living.

Reference: U.S. News & World Report (Feb. 17, 2021) “Discuss Your Estate Plan With Your Children”

What Do I Need to Know about Roth IRA Conversions?

People with large tax-deferred accounts they intend to leave to their children can eliminate a tax burden on their heirs, by converting the tax-deferred money over time. By doing the conversion this way, says a recent article from The Wall Street Journal entitled “Roth IRA Conversions: What You Need to Know,” the cost is manageable and the heirs won’t have to pay taxes.

For a Roth conversion, the owner pays income tax on every dollar converted, which makes sense for people who retire early and want to avoid higher taxes in the future, or when children inherit the assets.

Recent changes require account owners to start taking required minimum distributions at age 72. The withdrawals can be costly in two ways: pushing household income into a higher tax bracket and forcing Medicare premiums higher.

Withdrawals from a Roth IRA, on the other hand, are not taxed and have no required distributions. It is tax-free money, since taxes are already paid. It can be a cash fund as needed, or a tax-free legacy to heirs.

The interest in Roth conversion increased since Congress tightened rules for inheriting tax-deferred assets. In the past, heirs had a lifetime to take withdrawals from inherited IRA accounts. Now, only surviving spouses and a small group of other individuals have this option. For everyone else, there’s a ten-year window to empty the account, which means increased income tax bills, especially for heirs who are already in high tax brackets.

Those who do the conversion over an extended period of time eliminate a tax timebomb for heirs and funds can be invested more aggressively to maximize growth.

In the simplest type of conversion, the owner notifies the custodian of the account of their wish to move assets from the tax deferred account to the Roth account. They need to specify how much they want to move, what funds they want to move and what date they want the transaction to happen. When taxes are filed the next year, all of the money transferred is treated as ordinary income.

Doing this during a market decline is a smart move. One investor moved $200,000 of stock mutual funds during the market downturn, which cost him about $85,000 in federal and state taxes. The converted funds have since bounced back to around $320,000, above where they were before the market decline. Those gains in a tax-deferred account would have been taxable, but now, they are tax free.

Seniors who have low taxable income, but large tax-deferred accounts, might consider doing a conversion every year before reaching age 72, when they must begin taking required minimum distributions.

Reference: The Wall Street Journal (Nov. 19, 2020), “Roth IRA Conversions: What You Need to Know,”

The Biggest Estate Planning Mistakes and How to Avoid Them

Heirs who are prepared to inherit wealth, with families who talk about wealth and have an estate plan, will do better than those who do not, says the West Haven Observer’s recent article “5 Estate planning disasters you’ll want to avoid.” A constantly changing legal and tax environment presents significant challenges, but a few simple steps may save your beneficiaries from the expense and stress of these common estate planning mistakes.

1. Not designating beneficiaries properly. This is one of the most common mistakes, and one that cannot always be fixed. It’s easy to forget whose name you put on a pension or life insurance plan thirty years ago. However, failing to check those beneficiaries, especially if your life has undergone big changes, can lead to the wrong people enjoying the proceeds.

Using beneficiary designations is an excellent way to bypass the process of probate, since assets that pass this way are not subject to probate. Depending upon where you live, probate can be a long, drawn out process. A beneficiary designation is far simpler and more efficient.

Failing to name a beneficiary when setting up bank accounts, opening CDs, and savings accounts is a common error. This can be fixed by making these accounts “TOD,” or Transfer on Death, and the account goes directly to your beneficiary.

Your will does not control any beneficiary designations. That’s why this step is so important.

2-Designating a minor as a beneficiary. You love your grandchildren, but unless they are adults, they cannot inherit assets until they are 18 or 21, depending on the laws of your state. If a minor does receive an asset, the court appoints a guardian to supervise and manage the assets. Your estate planning attorney will advise you on your individual situation, but one alternative is to list a guardian for the minor child inside the will, so the court appoints the person who you choose to manage the property until the child becomes of age.

Another means of providing for young children or grandchildren is to create a trust. The trust names a trustee who is usually a trusted friend or relative who is knowledgeable and responsible. They manage the assets on behalf of the child. The trust also permits assets to pass without probate.

3-Failing to fund a trust. All too often, this is the weak link that breaks the estate. Placing assets within the trust is called funding. Usually this means changing the ownership of bank accounts or real estate from being owned by an individual to being owned by the trust. If the trust is not funded and the will has instructions that seemingly contradict the trust, the asset will need to go through probate and the trust instructions will be ignored.

4-Leaving a tax nightmare for heirs. One of the many advantages of passing on real estate or other assets that appreciate that beneficiaries get a “step up” in basis. That means the heirs are not responsible for any income taxes on the appreciated assets. This can be a very big benefit. There are exceptions—inherited IRAs and 401(k)s don’t have this advantage. However, the recent passage of the SECURE Act has taken away many tax benefits for IRA heirs. Most non-spouse beneficiaries must fully withdraw the entire amount from the IRA or 401(k) within ten years, and the withdrawal is considered ordinary income. It could leave your heirs with a huge, unexpected tax bill.

There is a workaround. By converting some or perhaps all of your retirement accounts to a Roth IRA during your lifetime, you can pay the taxes when converting the IRA to a Roth IRA at your current tax rate, which may be lower than your children or grandchildren’s rate. When you die, any money in the Roth IRA goes to heirs completely tax free.

5-The biggest mistake of all is not having an estate plan. Thinking about your legacy plan, mortality and incapacity is not fun for anyone. However, by spending the time and resources in creating an estate plan, you spare your loved ones from an inordinate amount of stress and expenses, which they will appreciate. One of the best gifts you can give your loved ones is a well-thought out, properly created and executed estate plan.

Reference: West Haven Observer (Nov. 12, 2020) “5 Estate planning disasters you’ll want to avoid”

Retirement Account Beneficiary Choices and Your Estate

A designated beneficiary is the person named on a retirement or investment account to inherit the asset if you die. That’s the simple part. What gets complicated is when people don’t think it’s such a big deal, says a recent article “5 Mistakes To Avoid With Retirement Account Beneficiary Selections” from Forbes. Mistakes made about beneficiaries can be costly and sometimes, unfixable. You could accidently disinherit a child or leave money to an ex-spouse.

Even if you have done all the right estate planning, mistakes with beneficiaries can happen. Just remember this very simple fact: your will does not control your retirement accounts and it may not control any accounts where you have been asked to name the person who inherits the asset, like a life insurance policy.

A will can also push your estate into the probate process, which can have some significant pitfalls. If you have a living trust but neglect to fund it, the assets left outside of the trust might also have to go through probate. The best way for most people to pass assets like retirement accounts is to have them go directly to a beneficiary.

Other accounts that pass via beneficiary designation are usually 401(k)s, IRAs, Roth IRAs, life insurance, annuities, and investment accounts that have Transfer on Death (TOD) options. Using beneficiary designations may allow your heirs to receive assets in a tax-efficient and fast manner.

What are the top five mistakes people make for beneficiary designations?

Forgetting to name a beneficiary. This happens very commonly when people are young adults. It’s hard to imagine needing to name an heir when you are young and healthy, but not naming anyone creates headaches.

Ignoring special circumstances. When you have an heir with an addiction problem, one who has trouble managing money or who is preparing to leave a marriage, leaving them a large sum of money can create more problems. If your loved one has special needs and receives benefits from the government, an inheritance could put all their aid at risk. An estate planning attorney can help create a Special Needs Trust and plan for their future.

Using the wrong name. It sounds silly, but it happens often. If your loved one’s name is Jane Doe, or there are family members with very similar names, you’ll need to use more information to identify them, like birthdates, Social Security numbers and even details about their relationship to you. Not providing enough clear information, could send your asset into the wrong hands.

Neglecting to update your beneficiaries. The person you name as your beneficiary when you are in your 30s, may not be the same person you want to inherit your assets in your 60s. If you have remarried, you must change all beneficiary designations to protect your current spouse. If you have had children or additional children since you first purchased a life insurance policy, you’ll need to be sure that all your children are named on that policy. Every few years, just as you need to review your estate plan, you need to update your beneficiaries.

Failing to discuss your beneficiaries with your estate planning attorney, tax, and financial advisor. There are complications that can occur with an inheritance. Being pushed into a higher bracket sounds like a nice problem to have, until the tax bill comes due. Your estate planning attorney will be able to work with you and your loved ones to protect your legacy and their future.

Reference: Forbes (Oct. 25, 2020) “5 Mistakes To Avoid With Retirement Account Beneficiary Selections”

How to Benefit from a Roth IRA and Social Security

When originally created, Social Security was designed to prevent the elderly and infirm from sinking into dire poverty. When most working Americans enjoyed a pension from their employer, Social Security was an additional source of income and made for a comfortable retirement. However, with an average monthly benefit just over $1,500 and few pensions, today’s Social Security is not enough money for most Americans to maintain a middle-class standard of living, says the article “3 Reasons a Roth IRA Is a Perfect Supplement to Social Security” from Tuscon.com. It’s important to plan for additional income streams and one to consider is the Roth IRA.

Roth IRAs can be funded at any age. Many seniors today are continuing to work to generate income or to continue a fulfilling life. Their earnings can be put into a Roth IRA, regardless of age. If you are still working but don’t need the paycheck, that’s a perfect way to fund the Roth IRA.

Withdrawals from a Roth won’t trigger taxes on Social Security benefits. If your only income is Social Security, you probably won’t have to worry about federal taxes. However, if you are working while you are collecting benefits, once your earnings reach a certain level, those benefits will be taxed.

To calculate taxes on Social Security benefits, you’ll need to determine your provisional income, which is the non-Social Security income plus half of your early benefit. If you earn between $25,000 and $44,000 as a single tax filer or between $32,000 and $44,000 as a married couple, you could be taxed as much as 50% of your Social Security benefits. If your single income goes past $34,000 and married income goes past $44,000, you could be taxed on up to 85% of your benefits.

If you put money into a Roth IRA, withdrawals don’t count towards your provisional income. That could leave you with more money from Social Security.

A Roth IRA is flexible. The Roth IRA is the only tax-advantaged retirement savings plan that does not impose Required Minimum Distributions or RMDs. That’s because you’ve already paid taxes when funds went into the account. However, the flexibility is worth it. You can leave the money in the account for as long as you want, so savings continue to grow tax-free. You can also leave money to your heirs.

While you don’t have to put your savings into a Roth IRA, doing so throughout your career—or starting at any age—will give you benefits throughout retirement.

Reference: Tuscon.com (Oct. 5, 2020) “3 Reasons a Roth IRA Is a Perfect Supplement to Social Security”

What COVID-19 Does to Roth Conversions

With a combination of lowered 2020 tax liability, the potential for future tax increases and potentially lower portfolio values, we are in uncharted financial waters. However, all of these factors may make a Roth conversion more attractive than ever, according to the article “Covid-19 and the CARES Act enhance the Roth conversion game” from the Jacksonville Business Journal.

A quick look first at essentials of the traditional and Roth IRAs:

Tradition IRA contributions are tax deductible.

• Growth inside the account is tax-deferred,
• Qualified distributions are taxed as ordinary income, and
• Required minimum distributions must begin at age 72.

Roth IRA contributions are not tax deductible.

• Growth inside the account is tax free,
• Qualified distributions are tax free, and
• There are no required minimum distributions.

Roth IRAs are an essential part of both estate and retirement planning. Converting a traditional IRA to a Roth IRA lets you decide when you or your beneficiaries pay taxes. Convert all of your IRA to a Roth, and pay the taxes up front, based on the year the conversion is made. If you have a low-income year, and the value of your IRAs is low, that’s the time to do the conversion.

Just be mindful that making this move for a large amount of money could potentially move you into a higher tax bracket. Being strategic and moving a portion of your IRA could make more sense, especially if you expect that you’ll be in a higher tax bracket during retirement, or if you anticipate that your ultimate beneficiary may be in a higher tax bracket within ten years following their inheritance. (As a result of the SECURE Act, inherited IRA accounts must be emptied within ten years after they are received.)

You’ll also need a plan to pay the taxes on that conversion. In a perfect world, those taxes would be paid from funds outside of your retirement accounts. If the only way to pay this tax is by using funds from your IRA, you can have the funds withheld during the conversion. Be sure to run the numbers before doing the conversion. If you pull money from your IRA account to do the conversion, there will be less money to grow long-term for you, and it will be included in your taxable income for the year.

We all like something for nothing, but there are costs to Roth conversions. The five-year rule requires that a Roth needs to exist for five years, before you can take out money tax free. You’ll need to be sure that you have enough cash on hand to live on for five years after the conversion. However, that’s not all. There are a number of different variations on the five-year rule, depending on your situation. If you are under age 59½ and take a distribution of profits before the five years, you will get hit with a 10% penalty without an allowable exception on the amount you converted. An experienced estate planning attorney will be able to help you make a strategically sound decision.

Reference: Jacksonville Business Journal (July 13, 2020) “Covid-19 and the CARES Act enhance the Roth conversion game”