Planning for the Next Generation- Roth Tricks

By Jeanne Blackmore and Tanner Freeman

In this article, we discuss some simple strategies to leverage a child or grandchild’s ability to fund Roth retirement accounts to maximize the tax-efficient generational transfer of wealth. 

If you have attended a client meeting at Trust Company of Vermont, you may have been encouraged to start Roth retirement account planning, whether through conversions of regular retirement accounts to Roth retirement accounts or maximizing contributions to Roth retirement accounts. In this case, you already know that the primary benefits of Roth retirement accounts are as follows: 

• No required minimum distributions (RMDs) during the account holder’s lifetime. 
• Roth IRA investments can grow tax-free for as long as you live. 
• If married, the surviving spouse can inherit the Roth IRA and continue to let it grow without mandatory withdrawals. 
• After both spouses pass, heirs can let the inherited Roth IRA grow for an additional 10 years before withdrawals are required. 
• This structure provides flexibility, enhances estate planning, and maximizes tax-free growth for future generations 

Contributions to a Roth retirement account are made with after-tax dollars; i.e., using earnings on which the account owner already paid income taxes. As a result, it is often difficult for a child or grandchild to afford the expense of funding an employer-sponsored Roth 401(k), 403(b) or 457(b) account and/or a Roth IRA. This is especially true in the current high cost of living environment. In other words, a child or grandchild’s after-tax salary in the years following graduation might not be sufficient to cover living expenses and also allow for the maximum contribution to a Roth 401(k) account plus an additional contribution to a Roth IRA. The current annual Roth 401(k) contribution limit is $24,500 (before employer match) and the current Roth IRA contribution limit is $7,500. As you might imagine, 35 or more years of permanently tax-free growth on annual Roth account contributions of up to $32,000 is significant…it would be a shame to lose that investment opportunity!

An effective way to transfer wealth to a child or grandchild is to make annual gifts to allow him or her to maximize Roth retirement account savings.

Specifically, a parent/grandparent could make annual gifts to a child/grandchild to supplement income so the child/grandchild can afford to make the maximum after-tax contribution to his/her Roth 401(k) plan through work. A parent/grandparent could also make gifts to a child to fund annual contributions to a Roth IRA. Making lifetime gifts to a child/grandchild to fund Roth accounts will generate more wealth than gifts to fund a traditional 401(k) plan and/or a traditional IRA, or than an eventual inheritance of the gifted funds. This is because assets in a traditional retirement account are subject to income tax when withdrawn and are also, are subject to required minimum distribution rules. Consider the following examples.

Suppose your child has just started his or her first job out of college and is currently contributing $400 monthly to an employer sponsored Roth 401(k) plan for total yearly contributions of $4,800. You and your spouse decide to annually gift funds to your child to allow him or her to maximize that yearly Roth 401(k) contribution. Your child increases the Roth 401(k) monthly contribution from $400 to $2,041.66, for a total yearly contribution of $24,500. Because 401(k) contributions must come from the plan participant’s paycheck, you send your child $1,641.66 monthly to cover the loss of income from the increased Roth 401(k) contribution for a total yearly gift of $19,700. This $24,500 would grow tax free in your child’s Roth 401(k) account for the remainder of his/her lifetime; however, if he or she needed to withdraw funds from the account at some point in retirement, no income tax would be due. In addition, the increased contribution to the Roth 401(k) would allow your child to become eligible for any employer matching 401(k) contribution.

One potential drawback to funding a Roth 401(k) is that funds cannot be withdrawn by the account owner without penalty until age 59 ½. Thus, an alternative (or concurrent) strategy for a parent is to fund a child’s Roth IRA first, and any additional gift would allow your child to increase (but not necessarily max out) yearly Roth 401(k) contributions. Contributions to a Roth IRA (not earnings) may be withdrawn penalty-free at any time. Using the same example as above, the first $7,500 of the gift would be used to make the maximum annual contribution to your child’s Roth IRA. Your child would then use the remaining $12,200 ($1,016.66 per month) to increase his/her monthly Roth 401(k) contribution from $400 to $1,416.66 for a total yearly contribution of $12,200. 

In either of the above scenarios, after 20 years and assuming a 9% return and no additional contributions, your child’s Roth account(s) would grow tax-free from $24,500 to $137,308 and assets would not be subject to income tax when withdrawn. If your child were to contribute $24,500 to Roth account(s) yearly, the growth would be significantly greater.

These strategies enable a parent or grandparent, through disciplined annual gifting, to transfer wealth from a bucket that will be exposed to future income tax to a bucket that will not be subject to future income tax. We do not know whether changes to tax laws might someday eliminate the opportunity to contribute or convert to Roth retirement accounts. In the event of any such law change, it is unlikely (though not guaranteed) that existing Roth accounts would retroactively lose their tax-favored status. Accordingly, we encourage clients to take advantage of Roth planning such as that described in this article for as long as these tax-favored accounts are available.