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Reader Asks: What’s The Cheapest Way To Help Adult Children?


You could cash in a pretax IRA, a Roth IRA or a highly appreciated stock. One strategy might be much better than the others.

“We want to make a sizeable gift to our children—daughters in their 40s. Yes, we can afford it.

“Should we liquidate assets, incurring a tax? Or should we take advantage of the low mortgage rates to borrow money and hope the government does not eliminate step-up in basis?

“Our taxable money consists of profits of over 75%. We have substantial amounts in traditional IRAs and Roth IRAs, as well as a “California” value in our home. We have virtually no debt. I am confident I can find a place to deduct the interest.

“Age, 75. We’re in top brackets. So are our daughters.”

Michael, California  

My answer:

You’re fretful about taxes on prosperous people. This is a nice problem to have. But let’s see what a little arithmetic can do for you.

Your dilemma is a common one and it’s somewhat complicated, involving as it does the interplay between income taxes and death taxes. I don’t know your particulars, but I surmise that your family will incur a federal estate/gift tax as assets pass to the next generation. (California doesn’t impose tax on inheritances, and the federal government exempts bequests to a spouse.)

The present federal exemption is a generous $23 million per couple, but that amount gets cut in half when the 2017 tax law sunsets at the end of 2025. It is highly likely that you or your wife or both will be alive when the boom is lowered. So you should be thinking about estate tax.

I assume you are taking advantage of the $16,000 annual gift tax exclusion. This is per donor per recipient per year, so if your daughters are married you and your wife can disburse $128,000 a year without eating into your lifetime gift/estate exemption.

As for income taxes, you have a lot of balls in the air:

—The pretax IRA is taxable at high (ordinary income) rates as dollars come out. Having reached age 72, you are now compelled to withdraw a certain amount each year. Your survivors will also have withdrawal mandates on any pretax IRA they inherit from you.

—The Roth IRA money is completely free of tax. It’s also free of a withdrawal mandate so long as either you or your wife is alive.

—Any stock you have in a taxable account throws off dividends taxed at a reduced rate. As for the appreciation, that doesn’t get taxed until you sell, so you are, I presume, in the habit of hanging onto winners indefinitely.

You’ve evidently cleaned out all the losers from your taxable portfolio, and bonds, too. What are left are stocks that have quadrupled or better from your purchase price. Selling now means realizing a capital gain. Even though this gain is taxed at the reduced dividend rate, you want to avoid selling a winner. That’s because hanging on until you die gives you a “step-up” exempting all capital appreciation up to that point from tax.

Now let’s suppose you want to come up with $100,000 so you can hand it to your kids. This is money they will eventually inherit, but that day could be a long time away. I’ll assume they would find a windfall more precious now, when they have college tuition or a home renovation to pay for, than when they are in their 60s.

You have four ways to scare up cash.

(a) You could withdraw some pretax IRA money. That would be painful. If you are in the highest federal bracket, and not quite in the highest state bracket, your combined marginal tax rate is 47.3%. So you’d need a $190,000 distribution to deliver $100,000 of spending money.

(b) You could sell some of your appreciated stock, paying a capital gain tax of 34.1%. (That number is the base federal rate, plus the 3.8% investment income surcharge, plus the California tax.) You’d select shares with the smallest percentage appreciation. From your letter I gather that the best you can do is to sell something whose cost basis is 25 cents per dollar of current value. In that case you’d have to liquidate $134,000 of assets to generate $100,000 for the kids.

Even though the tax bill for choice (b) is only $34,000, it hurts because you’re missing out on a step-up. A dollar of stock appreciation, then, is quite unlike a dollar inside a pretax IRA, which is doomed to incur an income tax at some point.

(c) You could cash in some Roth money. There’s no tax due, so the withdrawal would be only $100,000. But a Roth account, which promises years of tax-free compounding, is a precious asset. Ordinarily you part with a Roth only when all other options are exhausted.

(d) You could borrow the money.

Which is optimal? My answer may surprise you. I recommend (d), even though it sounds a little nutty for a 75-year-old to be taking out a mortgage.

To know for sure which of these four options is superior you’d have to know what the stock market is going to do, when you’re going to die and when your wife is going to die. You don’t know any of these things.

The best you can do in a situation like this is to make some assumptions that have unknowns landing in the middle of their plausible ranges. So I am going to assume that stocks return 5% a year and that either you or your wife dies in the year 2032. Let’s see how the accounts play out.

Mentally segregate $190,000 of your pretax IRA, $134,000 of your taxable stocks and $100,000 of your Roth account. For a fair comparison, all of these sums have to be invested in the same stock index fund earning 5%.

With option (a), the pretax IRA vanishes. The Roth grows in ten years to $163,000. The taxable account gets hit with a bit of dividend taxes along the way but enjoys a free pass on all its appreciation. A key factor here is that California is a community-property state, so marital assets enjoy a full step-up at the first death. The taxable account will be worth an aftertax $209,000 in 2032. Combined ending value: $372,000.

With option (b), the pretax IRA survives but is subject to mandatory withdrawals for the next ten years. These distributions get whacked by tax at the stiff ordinary-income rate; what’s left of them go in a taxable account holding that same stock index fund. In 2032, we will hypothesize that the taxable account is liquidated and a lot of the proceeds used to do a Roth conversion on the $179,000 left inside the pretax IRA. Ending values: $342,000 of Roth money and another $42,000 of cash, for a combined $384,000.

With option (c), the original Roth account disappears. As with (b), we assume a Roth conversion in 2032 of what’s then left in the pretax IRA. After paying tax on the conversion, the family would have $251,000 of cash sitting around, most of it from letting the taxable account grow. Combined value in 2032: $430,000.

In this comparison, at a point frozen in 2032, (c) looks better than (b). Yet in all probability the Roth can be kept alive a good while longer, so plan (b)’s richer Roth balance makes it quite competitive in the long run. These are both reasonable choices.

Neither (b) nor (c), however, is as good as (d), the debt-financed strategy.

For option (d), I’m assuming a 4% loan that compounds for ten years and then is paid off with $148,000 of cash. As in options (b) and (c), we have a Roth conversion in 2032 of whatever is left inside the pretax IRA. Ending values: $342,000 in the Roth plus $103,000 of cash, for a combined $445,000.

The borrowing option looks good for two reasons. One is that it preserves all three tax dodges (conventional IRA, Roth IRA and step-up). The other is that it has you financing stocks earning 5% with a loan costing 4%. This adds a bit of risk to your finances; stocks might do much worse than 5%. I think you can handle that risk.

That 4% loan cost is about what people pay these days on a 20-year mortgage. The aftertax cost would be lower if you can find some way to deduct the interest. You think you can do that. I’m skeptical.

Interest is deductible on loans used to…


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