Holiday Gift Tax Planning Suggestions for Federal Employees and Retirees

As a rule, individual retirement arrangements (IRAs) cannot be gifted during a traditional IRA owner’s lifetime. Once the before-taxed funds are withdrawn from a traditional IRA, they are fully taxable to the traditional IRA owner.

But funds outside of an IRA (such as money held in a bank and or a credit union checking/savings account) can be gifted to children, grandchildren and parents. These gifts can be done free of federal gift tax. This column describes how federal employees and retirees can use gifting to enhance the Roth IRA savings of their children, grandchildren and parents.

Gifting Rules for 2023

During 2023, any individual can give (via a gift) up to $17,000 ($34,000 if the individual is married) to any other individual and not be subject to any federal gift tax. The federal gift tax is separate from the federal income tax.

There is no limit on the number of individuals that one individual can make a gift. These gifts are potentially federal gift tax free. In addition, these gifts do not count toward the federal estate/gift tax lifetime exemption which for 2023 is $12.92 million per individual, or $25.84 million for a married couple.

A gift does not have to be in the form of cash. A gift can consist of a tangible asset. For example, if a grandparent buys a new car as a graduation gift for a grandchild, then the car is considered a gift.

For the discussion of gifting in this column, all gifts discussed are cash gifts. In particular, how cash gifts can be used in conjunction with funding a Roth IRA account.

Cash Gifts for Making Roth IRA Contributions

Any individual who has earned income (earned income includes wages, salary, or net self-employment income) during 2023 is eligible to make a Roth IRA contribution. The 2023 IRA contribution limit is $6,500 ($7,500 if an individual is age 50 or older as of December 31,2023). It makes no difference where the cash used to contribute comes from. The cash contribution can come from the Roth IRA owner’s checking or savings account.

A parent or grandparent can give a child or grandchild the money to make their annual Roth IRA contribution. The $6,500/$7,500 IRA contribution limit for 2023 is well below the 2023 $17,000 gift tax exclusion. If a parent has a child, then the parent can gift the child and the child’s spouse the $6,500/$7,500 in which both spouses can use to fund their 2023 Roth IRA contributions. In so doing, the parent stays below the $17,000/$34,000 gift tax exclusion amount.

Note the following:

(1) An individual who makes the gift (the gift “donor”) cannot make the gift with “strings attached” to the gift recipient (the gift “donee”) as to how the gift is to be used. In the example above in which a parent gifted money to a child for the purpose of funding the child’s IRA contribution, the parent cannot tell the child that the gifted funds are to be only used to contribute to a Roth IRA. If the parent did, then the funds given to the child is not considered a gift; and

(2) In the example above, the child and the child’s spouse have until April 15,2024 to make their 2023 Roth IRA contribution. They should be aware that in order to contribute to a Roth IRA, an individual’s adjusted gross income (AGI) has to be below AGI limits as set by the IRS.

Many grandparents will be delighted to a make a cash gift to a young working grandchild for funding the grandchild’s Roth IRA in order for the grandchild to help save for their future retirement. For example, a young grandchild who worked over this summer and earned enough is eligible to contribute to a Roth IRA. Accumulating a Roth IRA retirement nest egg starting at an early age, with 40 to 50 or more years of compounded tax-free growth puts the child on the right path towards what will hopefully be a secure retirement.

Cash Gifts to Pay the Taxes Due on Roth IRA Conversions

Cash gifts can be made to children or grandchildren in order to help the child or grandchild pay the federal and state income taxes due on a Roth IRA conversion. Between now and December 31,2025 is good time for individuals to perform Roth IRA conversions because federal individual marginal tax rates are low, a result of the passage of the Tax Cuts and Jobs Act of 2017 (TCJA).

Unless Congress renews the TCJA, effective January 1,2026 individual tax rates will revert to the higher tax rates they were in 2017, prior to the passage of the TCJA.

A cash gift during 2023 of $17,000 (the annual gift tax exclusion amount) can allow a child in a 30 percent overall (federal and state) marginal tax bracket to convert a traditional IRA worth $56,667 to a Roth IRA and use the $17,000 to pay the federal and state income taxes due on conversion. More of a traditional IRA can be converted if a child is a lower overall marginal tax bracket.

This gifting strategy can work particularly well for adult children who have larger traditional IRAs that can be converted to Roth IRAs. It should not be a problem if a larger amount of cash (more than the exclusion amount of $17,000) has to be gifted to help pay the taxes due on a larger Roth IRA conversion. This is because gifts beyond the $17,000 exclusion amount will cut into the gift donor’s lifetime gifting exemption amount ($12.92 million per individual; $25.84 million per married couple during 2023) which should not be a problem for most donors.

It needs to be emphasized that the larger the Roth IRA conversion, the larger the tax bill resulting from the conversion. Therefore, in deciding how much of a child’s traditional IRA portfolio should be converted, the child’s projected tax brackets should be considered.

Gifting “Up” Rather than Gifting “Down”

As discussed above, estate planning normally involves parents or grandparents making gifts to children or grandchildren. The purpose of lifetime gifting is to reduce a parent’s or grandparent’s gross estate while the parent or grandparent is living. However, effective estate and tax planning can be performed by reversing the gifting process in which the children gift to the parents or grandparents in order to pay the taxes due on the parent’s or grandparent’s traditional IRAs.

A parent’s or grandparent’s conversion of a traditional IRA to a Roth IRA can be extremely financially beneficial to a child or grandchild who will likely inherit the traditional IRA upon the parent’s or grandparent’s death.

There are two reasons:

First, when a child or a grandchild inherits a traditional IRA, the child/grandchild cannot convert the traditional IRA to a Roth IRA.

Second, when a child/grandchild inherits a traditional IRA the traditional IRA funds must be withdrawn (and taxes have to be paid) withing 10 years of the death of the traditional IRA owner. If the inherited traditional IRA is large, the child/grandchild will be subject to a substantial amount of federal and state income taxes.

The following example illustrates:

Sheila is in a high-combined federal and state marginal tax bracket (40 percent) and is the sole beneficiary of her mother’s $750,000 traditional IRA. Her mother is subject to huge required minimum distribution (RMDs) from her traditional IRA. Sheila’s mother has other funds to live off of including a guaranteed pension and a sizeable brokerage account. She does not need her traditional IRA to pay her living expenses. However, because Sheila’s mother is past her required beginning date for taking RMDs, she must take an RMD every year.

When Sheila inherits her mother’s traditional IRA (Sheila is the sole beneficiary) , she will likely be subject to the 10-year rule in which she must withdraw all of the inherited IRA within 10 years of her mother’s death and pay full federal and state tax by the end of the 10th year after the death of her mother. Given Sheila’s projected tax rate, Sheila will likely lose a sizeable portion of the inherited IRA due to taxes, especially if future tax rates increase.

Suppose Sheila gifts to her mother a sufficient amount of cash in order for her mother to convert the entire traditional IRA to a Roth IRA and pay the taxes due in the year of conversion.

If the entire traditional IRA is converted to a Roth IRA, then in the year of conversion her mother would likely be pushed into the highest federal marginal ax bracket (37 percent) resulting from the addition of 37% of $750,000, or $277,500 added to her income. Sheila has a sufficient amount of cash to gift her mother $277,500 to pay the taxes due on conversion.

Even if Sheila does not have that amount of cash to gift to her mother at one time, her mother can perform a series of smaller annual Roth IRA conversions in order to have the entire traditional IRA converted over a few years.

What are the benefits to Sheila and to her mother as a result of a full Roth IRA conversion? First, her mother will no longer be subject to RMDs. This means her mother’s annual tax bill will be lower each year. Her mother could pay less for Medicare Part B and Medicare Part D monthly premiums (which depend each year on her adjusted gross income). Sheila’s mother does not need to make withdrawals from the converted Roth IRA, meaning that the funds in the Roth IRA can continue to grow income-tax free for the rest of her life.

For Sheila, the benefit is that she will inherit a tax-free Roth IRA upon her mother’s death. While Sheila must withdraw the inherited Roth IRA within 10 years of her mother’s death, the Roth IRA continues to grow income tax-free, and Sheila can wait until the end of the 10th year to withdraw the inherited Roth IRA with no RMDs during the 10-year period.

In case Sheila as a result of inheriting her mother’s Roth IRA may be subject to federal and/or state tax estate tax, her mother can name her grandchildren (Sheila’ children) as her Roth IRA beneficiaries, thereby bypassing Sheila’s estate.

Gifting “up” the family tree can potentially be advantageous to multiple generations, a result of the generous gifting levels currently available.