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When does it make sense to fund gifts with retirement savings?

Cash Flow and Retirement

Using your traditional IRA or employer-sponsored retirement account to fund gifts generally is a bad idea. Withdrawing those funds will immediately trigger income tax (plus a 10% penalty if you’re under 59½), not to mention the loss of continuing tax-deferred growth in the future. However, under 
certain circumstances, funding gifts with your retirement savings may provide a tax advantage. 

High Exempion Through 2025

The federal gift and estate tax exemption is $13.61 million ($27.22 million for married couples) in 2024. But in 2026, those numbers are scheduled  to drop to $5 million and $10 million, respectively.

To lock in the higher exemption amounts before they expire, consider making substantial gifts by the end of 2025. If the funds for such gifts are unavailable elsewhere, it may make sense to tap retirement accounts, so long as the anticipated estate tax savings outweigh the income tax cost.

Let’s look at an example. Suppose that Meredith, a single parent,  has a current net worth of  $7 million, including $1.5 million  in a traditional IRA. When she  dies in 2026, the exemption has  dropped to $6.46 million, while  her IRA balance has grown  to $1.75 million and her  overall net worth has grown  to $8.46 million. Her estate  tax is 40% x ($8.46 million – $6.46 million) = $800,000. 

Suppose, instead, that Meredith withdraws the funds from her IRA and gives them to her two children in 2024. The gift is shielded from gift tax by the exemption. Assuming she’s in the 35% tax bracket (and is over 59½), she’s liable for federal income tax of 35% x $1.5 million, or $525,000. By withdrawing the IRA funds, she avoids $700,000 in estate tax (40% x $1.75 million).

Right Move

Granted, the previous example is oversimplified. But the point is clear: In some circumstances, estate tax savings outweigh  income tax costs, and using an IRA to fund gifts can be a reasonable strategy. Talk to  your Lenox Advisor to learn whether it’s the right move for you.