Bob Carlson is editor of the newsletter Retirement Watch. He is a managing member of Carlson Wealth Advisors and chairman of the board of trustees of the Fairfax County (Virginia) Employees’ Retirement System. RetirementWatch.com
The upsides of IRAs and living trusts for retirement and estate-planning are widely known, but even savvy savers might not be aware that there’s a type of savings account that offers more tax advantages than any IRA can offer…and even prudent planners might never have heard of a few tremendously useful types of trusts.
Here are five very useful—and very underused—tools and trusts for retirement and estate planning. Reminder: For the options below, speak to a qualified financial adviser.
Health Savings Accounts (HSAs)—for retirement savings. You might already know about the advantages of HSAs when it comes to paying medical bills—these accounts let people pay health-related costs using pretax dollars. But the incredible upside of an HSA as a retirement savings tool receives much less attention. These accounts are “triple tax-free”—you contribute pretax dollars…investment profits earned inside the HSA are tax-free…and money isn’t taxed when it is withdrawn as long as it is used to pay for qualified medical expenses. No IRA or 401(k) can match that triple tax savings—you can either contribute pretax dollars with a traditional IRA/401(k)…or earn tax-free investment profits and take tax-free withdrawals with a Roth—never both.
Unfortunately, an HSA’s unparalleled tax advantages are largely wasted if, like most HSA owners, you simply put your contributions in a low interest rate savings account and then use the money to pay your medical expenses.
To maximize an HSA’s upside: Invest contributions in long-term investments such as equity mutual funds, and leave the money there as long as possible. Use other assets to pay near-term expenses.
If your HSA provider doesn’t offer appealing investment options, transfer to one that does. Unlike Flexible Spending Accounts (FSAs), with which HSAs are sometimes confused, money in an HSA can be kept there as long as you like—it doesn’t disappear early the following year. And unlike traditional IRAs and 401(k)s, HSAs have no required lifetime distributions.
Limitations of HSAs as retirement-planning tools: Most notably, you cannot contribute to an HSA if you have any health coverage beyond a high-deductible health plan—so if you’re enrolled in any part of Medicare, you won’t qualify. Important: This high-deductible health plan requirement applies only to making HSA contributions—you can withdraw money from an HSA in a future year even if you have more comprehensive coverage, such as Medicare.
And even if you do qualify for an HSA, your contributions will be capped—as of 2022, the limits are $3,650 per year for an individual or $7,300 for family coverage…though you can make an additional $1,000 “catch-up contribution” if you’re 55 or older by year-end.
Also: You will face taxes and penalties if you withdraw money from an HSA for non–health-related expenses (although no penalties once you’re age 65 or older), but this causes fewer issues than people tend to imagine. If you don’t have sufficient out-of-pocket medical bills to use up your HSA savings when you finally decide to tap this account, you can make withdrawals to reimburse yourself for earlier medical bills, even bills that were incurred many years before.
Helpful: IRS rules don’t officially cap how long in the past these reimbursed medical expenses can be, but as a rule of thumb they shouldn’t raise IRS eyebrows as long as the medical expense didn’t occur before you had an HSA.
529 plans—for estate planning. If you have kids or grandkids, you might have made contributions to 529 plans, a tax-advantaged way to save for educational expenses. But the potential of 529s as estate-planning tools is less well-known—these could be a way to get a large amount of money out of your estate fast without it counting against your lifetime estate and gift-tax exemption. Ordinarily the most one person can give another in a year without incurring tax consequences is $16,000, but with 529s there’s a special “five-year election” rule—you can give someone up to five times that $16,000 annual limit and, for tax purposes, treat it as if the gift was spread over five years. That’s $80,000 out of your estate in a single year per recipient with no tax consequences—if you have five grandkids, you could “superfund” five 529s for a total estate reduction of $400,000.
Unlike with most gifts, you don’t lose total control of your money when you fund a 529—you still can control how this money is invested…you can shift the money to a different beneficiary if, for example, the original beneficiary doesn’t go to college…and you even can withdraw the money for non-educational purposes, though that’s likely to trigger income taxes and a 10% penalty.
Qualified charitable distributions. Planning to make a charitable donation this year? If you’re older than 70½ and have money in a traditional IRA, whether you claim the standard deduction or itemize your taxes, giving this gift through something called a “qualified charitable distribution” (QCD) could make more financial sense than simply writing a check to the charity. With a QCD, the money you donate counts toward your required minimum distributions and is excluded from your taxable income. Ordinarily charitable donations are excluded from taxable income only for people who itemize their taxes, which is relatively uncommon under the current tax law.
To make a QCD: Instruct your IRA custodian to distribute money directly to the charity of your choice—the custodian might ask you to complete a form. Annual QCDs are capped at $100,000…and the recipients must be 501(c)(3) organizations.
Inheritor’s trusts. This underused type of irrevocable trust could be the solution if you have faith in your descendants’ financial savvy and want to give them control over the assets they inherit…but also want to protect those assets from creditors and other outside threats. With an inheritor’s trust, the adult child—not the parent—sets up the trust and has broad powers over its management and the distribution of its assets. That adult child can access the assets as needed…or leave the assets in the trust to shield them from creditors and divorcing spouses…or let assets pass to their children in a way that avoids future estate taxes. They get all of the benefits of outright asset ownership plus many of the protections of a trust. An inheritor’s trust does nothing to protect assets against misuse by its beneficiary, however, so they’re not appropriate for irresponsible heirs.
Details can vary, but generally with inheritor’s trusts, the adult child is named both the primary beneficiary and a trustee—if you’re leaving assets to multiple children, each will need his/her own inheritor’s trust. The adult child’s children or other relatives might be named secondary beneficiaries, but the adult child has broad power to alter those secondary beneficiaries.
As a trustee, the adult child also has sole control over the investment decisions within the trust. A co-trustee—either a trusted friend of the adult child or a corporate trustee—might be given sole power to make distributions from the trust, but the adult child has broad power to remove or replace that co-trustee, so the adult child truly is in control of the inheritance.
Charitable remainder trusts. This type of irrevocable trust offers a way to convert a highly appreciated asset into both a donation to your favorite charity and an income stream for you—without having the value of that asset diminished by capital gains taxes.
How it works: A highly appreciated asset, such as a piece of real estate, a small business or shares of stock, is transferred to the trust, which typically then sells the asset and reinvests the proceeds. The trust then makes payments to you, either for the remainder of your life or for a set number of years—IRS rules cap the size of these payments based on a number of factors. The remaining assets eventually pass to the charity, but you don’t have to wait until that happens to claim a tax deduction—you can take the deduction in the year the trust is funded based on the present value of the amount the charity is expected to eventually receive. This deduction might have to be spread over multiple years if it’s more than 50% of your adjusted gross income. A large charity even might be willing to handle the creation and administration of a charitable remainder trust, saving you the legal costs and hassles.