Trump Accounts: Take the Free Money, But . . .
They're not as revolutionary as a Roth IRA. They're not on the level of a 529." - Dave Ramsey on Trump accounts.
We have been getting questions about Trump accounts and the most effective way to use them.
If you want a deep dive into the nuances of these accounts, I suggest this article from Nerd’s Eye View - Why Taxable Custodial Accounts Are Better Than OBBBA “Trump Accounts” For Kids’ Savings
If you just want my shorter version, here it is1:
If you have a child under 18, opening a Trump account makes sense. Every child should have one. Employers might fund it, the government might fund it, a billionaire philanthropist might fund it. The only way to receive the free money is to have an account open, so it makes sense to open one. It doesn’t cost anything to open or maintain, and you never know what may happen in the future. So, you should open one, even if your kids aren’t eligible for any of the initial deposits today.
Whether you should fund that account with your own money is a different question entirely, and the answer depends heavily on your goals.
For example, if the money is for education, a 529 probably makes the most sense. If the money is for a new house when they are 30, a taxable custodial account probably makes the most sense. If the money is intended for the child’s future retirement, a Trump account converted to a Roth after they turn 18 may be part of the answer.
My 8-Year-Old Daughter as An Example
My daughter is 8 years old. If I were to contribute $5,000 to her Trump account every year until she was 18, I would have contributed $50,000, and at an 8% growth rate, it would be worth almost $73,000.
At that point, the account becomes an IRA.
If she never contributes another penny and lets the account continue to grow until she is 70, the account would be worth nearly $4 million. That sounds great, but since it is an IRA, all the money that comes out would be taxed as ordinary income, likely at or near the highest marginal rates. If she leaves the account to her kids or grandkids, they will be responsible for distributing the account over 10 years and paying ordinary income tax on the entire amount.
The Roth Conversion
If she were to convert the account to a Roth when she turned 18, she would have to pay tax on the $23k of gains at my tax rate (kiddie tax rules would likely apply) with funds outside the Trump account; otherwise, the money used to pay tax on the conversion would be subject to an additional 10% penalty.
Assuming I am feeling very generous and choose to gift her the money to pay the tax bill on her conversion (probably an extra $8 or $9k), by the time she was 70, she would still have the same $4 million, but none of it would be subject to income tax for her or her heirs.
The Taxable Custodial Account Option
Of course, if I had just put the money in a taxable custodial account for her, her income would be low enough that she would have owed no tax on the annual dividends, and she would likely be able to sell after graduating from college and pay 0% tax on her capital gains and have no restrictions on when she could use the money.
And the best part is, I would have saved the $8k or $9k I paid toward the tax bill for the conversion.
If the money continues to grow in a taxable account, it would be subject to tax, but those taxes would likely be at the more favorable rates associated with long-term capital gains and qualified dividends. The assets would receive a stepped-up basis upon her death, and her heirs would receive the proceeds tax-free.
The 529 Option
And even if my only goal was to get some money into her Roth account, I could leave $35,000 in a 529 account beyond what was needed for her education, use the money to fund her Roth contributions for a few years after she graduates, and avoid paying tax on the conversion like I would have needed to do had I used the Trump account.
Every Situation is Different
If there is ever a chance to get free money from a Trump account, you should take it. However, if you are considering gifting your child or grandchild money to give them a head start in their future, a Trump account may or may not be the answer. The right approach will depend entirely on your goals and coordinating the strategy with the rest of your financial plan.
Personal Note:
Just about everyone in my wife’s family was born in July. My wife, her sister, her mom, and her dad all have birthdays within a couple of weeks of each other.
So this week has been a celebration of everyone.
I use rough numbers and broad strokes in this article to keep it short and somewhat legible, but a proper tax analysis requires detail. If you want that, click the link for the longer Nerd's Eye View article.