What is the cheapest way to help adult children?

You can cash in a pre-tax IRA, a Roth IRA, or a popular stock. One strategy might be much better than the others.

“We want to give an important gift to our children, our daughters in their forties. Yes, we can afford it.

“Should we liquidate assets, incurring a tax? Or should we take advantage of low mortgage rates to borrow money and hope the government doesn’t eliminate base laddering?

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

“Age, 75 years old. We are in the top bracket. Our daughters too.

Michael, California

My answer:

You worry about taxes on wealthy people. It’s a nice problem to have. But let’s see what a little arithmetic can do for you.

Your dilemma is common and somewhat complicated, as it involves the interplay between income tax and death tax. I don’t know your details, but I assume your family will have to pay federal estate/gift tax as the assets pass to the next generation. (California does not impose an estate tax, and the federal government exempts bequests to a spouse.)

The current federal exemption is a generous $23 million per couple, but that amount will be cut in half when the 2017 tax law expires at the end of 2025. Chances are you or your wife or both will be alive when the boom is lowered. . You should therefore think about inheritance tax.

I’m assuming you take advantage of the $16,000 annual gift tax exclusion. It’s per donor per recipient per year, so if your daughters are married, you and your wife can shell out $128,000 per year without impinging on your lifetime gift/estate exemption.

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

—The pre-tax IRA is taxable at high rates (ordinary income) as the dollars roll out. Having reached the age of 72, you are now obliged to withdraw a certain amount each year. Your survivors will also have withdrawal mandates on any pre-tax IRAs they inherit from you.

—Roth IRA money is completely tax-exempt. It is also free of withdrawal warrants as long as you or your wife are alive.

—Any stock you have in a taxable account generates dividends taxed at a reduced rate. As for appreciation, it’s not taxed as long as you don’t sell, so I guess you’re used to hanging on to winners indefinitely.

You have obviously eliminated all the losers from your taxable portfolio, as well as bonds. What’s left are inventory that’s quadrupled or better than 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 gainer. That’s because hanging on until you die gives you a “step” that exempts any capital gains up to that point from tax.

Now suppose you want to find $100,000 so you can give it to your children. It’s money they’ll eventually inherit, but that day might be a long way off. I suppose they would find a more valuable windfall now, when they have tuition or a home renovation to pay, than when they are in their 60s.

You have four ways to scare the money away.

(a) You can withdraw IRA money before taxes. It would be painful. If you’re in the highest federal bracket, and not quite the highest state bracket, your combined marginal tax rate is 47.3%. So you would need a distribution of $190,000 to provide $100,000 spending money.

(b) You could sell some of your appreciated shares, paying a capital gains tax of 34.1%. (This figure is the basic federal rate, plus the 3.8% surtax on investment income, plus California tax.) You would pick the stocks with the smallest percentage appreciation. From your letter, I understand that the best you can do is sell something that has a base cost of 25 cents on the dollar of present value. In this case, you would need to liquidate $134,000 of assets to generate $100,000 for the children.

Even if the tax bill for choice (b) is only $34,000, it hurts because you’re missing a step forward. A dollar in stock appreciation is therefore quite different from a dollar in a pre-tax IRA, which is bound to incur income tax at some point.

(c) You may collect Roth Money. There is no tax to pay, so the withdrawal would only be $100,000. But a Roth account, which promises years of tax-free compounding, is a valuable asset. Usually you only part with a Roth when all other options are exhausted.

(d) You could borrow the money.

Which is optimal? My answer may surprise you. I recommend (d), although it seems a bit crazy for a 75 year old man to take out a mortgage.

To know for sure which of these four options is best, you need 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 this.

The best you can do in a situation like this is to make assumptions that the unknowns fall in the middle of their plausible ranges. So I’m going to assume that stocks earn 5% per year and that you or your wife die in 2032. Let’s see how the accounts go.

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

With option (a), the pre-tax IRA disappears. The Roth grows in ten years to reach $163,000. The taxable account is hit with a little dividend tax along the way, but gets a free pass on all its appreciation. A key factor here is that California is a community property state, so marital assets get a full first-to-die increase. The taxable account will be worth $209,000 after tax in 2032. Combined end value: $372,000.

With option (b), the pre-tax IRA survives but is subject to mandatory withdrawals for the next ten years. These distributions are taxed at the hard ordinary income rate; what’s left goes into a taxable account holding that same index fund. In 2032, we will assume that the taxable account is liquidated and much of the proceeds are used to perform a Roth conversion on the remaining $179,000 inside the pre-tax IRA. Final values: $342,000 in Roth cash and an additional $42,000 in cash, for a total of $384,000.

With option (c), the original Roth account disappears. As with (b), we assume a Roth conversion in 2032 of what is then left in the pre-tax IRA. After paying the tax on the conversion, the family would have $251,000 in cash, most of it coming from the growth of the taxable account. Combined value in 2032: $430,000.

In this comparison, at a point frozen in 2032, (c) looks better than (b). Still, in all likelihood the Roth can be kept alive quite a while longer, so the richer Roth equilibrium in plan (b) makes it quite competitive in the long run. These are two reasonable choices.

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

For option (d), I assume a 4% loan compounded over ten years, then paid off with $148,000 in cash. As in options (b) and (c), we have a 2032 Roth conversion of everything left inside the pre-tax IRA. Final values: $342,000 in the Roth plus $103,000 in cash, for a total of $445,000.

The borrowing option looks good for two reasons. The first is that it preserves the three tax dodges (conventional IRA, Roth IRA and step-up). The other is that it makes you finance stocks earning 5% with a loan costing 4%. This adds a bit of risk to your finances; stocks could do well below 5%. I think you can manage this risk.

That 4% loan cost is roughly what people are paying these days on a 20-year mortgage. The after-tax cost would be lower if you could find a way to deduct the interest. You think you can do it. I’m skeptical.

Interest is deductible on loans used to purchase income-generating assets (such as a stock portfolio or a strip mall) or, within certain limits, a home. But if you already own the asset and then borrow against it, using the proceeds for personal purposes (buying a boat or giving money to your children), you cannot deduct the interest.

On the other hand, you can reduce interest costs by using a margin loan instead of a mortgage. Interactive Brokers will lend against a portfolio of stocks at a rate slightly above 1%. There is another kind of risk with margin lending, which is that short-term lending rates will skyrocket as the Fed tightens. But maybe you can manage that risk as well.

With more money than you need for retirement, you have plenty of options to help your daughters. They are all pretty good, but some are slightly better.

I will offer one more point in favor of strategies that lean towards large Roth balances in the end. A Roth dollar is worth more than twice as much to an heir as a dollar in a pre-tax IRA, but both have exactly the same value on a tax return. If you are likely to pay inheritance tax, prefer Roth accounts.

Do you have a personal finance puzzle that might be worth a look? These may include, for example, lump sum retirement payments, estate planning, employee options or annuities. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Request” in the subject field. Include a first name and state of residence. Include enough detail to generate useful analysis.

Letters will be edited for clarity and conciseness; only some will be selected; the answers are intended to be educational and are not a substitute for professional advice.

More in the Reader Asks series:

Should I pay off my mortgage?

Should I put all my bond money in TIPS?

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