Trump Accounts – Part 2

Full Transcript:

Is my child’s Trump account going to be a tax time bomb?

In my last video, I reviewed an illustrative example from the Trump accounts website of a Trump account growing to $13 million. Now, today I want to talk about an advanced planning strategy and three potential pitfalls. As a reminder, when your child takes a withdrawal from their Trump account, the pretax portion of that withdraw is subject to ordinary income taxes.

Additionally, if they’re under the age of 59.5, they’ll also have a 10% early withdrawal penalty. Now, the early withdrawal penalty may be waived for certain exceptions like higher education, but even then, taxes will still apply.

Now, once your child turns 18, the Trump account essentially transitions into an IRA. And if you go back to this example, at age 18, there was $271,000 in the Trump account. So now there’s $271,000 in the IRA. Now the parents contributed $5,000 per year from birth through age 17. So, of that, $271,000, $90,000 of it was the parents’ contribution. Now, the parents were not able to get a tax deduction for this contribution. So therefore, this money has already been taxed or it’s after tax.

Now of the rest of the balance $181,000. That money has not yet been taxed yet. So, it is pretax. Once it is in the IRA, your child could choose to do Roth conversions, moving some or all of the money directly to a Roth IRA. And then once in the Roth IRA, the money in there grows tax free and can be pulled out tax free.

Now, it’s important to note that at the time of the conversion, this is a taxable event. So, let’s look at an example. Let’s assume your child moves $60,000 from the IRA to their Roth IRA. Converting that 60 grand to Roth. At this time, two thirds of the IRA balance is pretax. So therefore, two thirds of the $60,000, or $40,000 is taxable.

This will show up on their tax return, and they’ll have to pay income rates on this Roth conversion. Now, if your child continues to do this year over year, they could completely move all of the money into their Roth IRA, having all of the former Trump account balance then grow tax free. This can be a really powerful strategy, especially if they do it early in their career when their income is low and therefore, they’re in a lower tax bracket paying a lower tax rate on these conversions.

However, let’s talk about a few potential pitfalls. The first potential pitfall is kiddie tax. If your child is under the age of 24, they may be subject to kiddie tax on their investment income. With kiddie tax, investment income is then taxed at the parents’ tax rate. So, although your child may think that this is going to be a really low tax rate based on their income, if there are subject to kiddie tax, it’s actually being taxed at the parents’ income, which could be a much, much higher tax rate.

The second thing to look out for is double taxation. As a reminder, the portion that the parents put in has already been taxed. So, when that is pulled out, that percentage of the withdrawal or in this case Roth conversion is not taxable. However, this requires good documentation both by the parents and then also by the child and reporting that correctly on their tax return. Otherwise, your child will be paying double taxes on your contribution.

And then the third thing, of course, especially with the Roth conversion, is the associated tax bill. So, in this example $40,000 is then reported on their tax return and they have to pay taxes on that conversion. If they take money out of the Trump account to pay those taxes, that withdrawal is now subject to a 10% early withdrawal penalty and income taxes.

Now I want to talk about one other potential pitfall. Reminder at age 18, your child gets full control of this account. If somebody handed 18 year old Trevor a $271,000 Trump account, there is a pretty good chance that 18 year old Trevor would have a really fast car and a big tax bill. Now, I hope your child is more responsible than 18 year old Trevor.

As you can see, there are a lot of potential pitfalls and way more nuances than I can ever cover in a video. So please check with your financial advisor and tax professional regarding your unique situation. If you found this video valuable, please like it and share it with your colleagues.