Article by: https://www.fiduciarytrust.com/
The central question of most estate plans is who receives your property when you die. For most families, the answer to that question involves your descendants. If that’s true, typically the next question is whether to also make gifts to your children or grandchildren during your lifetime.
Deciding If Lifetime Gifting Makes Sense for You
If you believe your estate might owe estate tax, gifting assets to your heirs throughout your life, rather than waiting until death, can be a powerful way to reduce the amount of taxes ultimately paid by your estate.
Even if taxes are not your primary concern, making gifts during your lifetime can allow your children to enjoy your gifts earlier and may make a great impact on their lives. It also provides you with the benefit of seeing your loved ones enjoy your gifts.
A well-thought-out financial plan can help you develop a gifting strategy that balances potential estate tax savings achieved by giving away assets with your own income needs and living expenses during your lifetime.
Will Estate Taxes Apply?
In 2021, an individual can transfer a total of $11.7 million at death or during their lifetime free from federal gift and estate taxes. Together, a married couple can transfer twice that amount—$23.4 million—free of tax.
If your assets total more than the exemption amount, the transfer price tag is high. Your estate will pay 40% in federal gift and estate tax for any assets transferred above the federal exemption.
In addition, if you’re giving assets to grandchildren (or future generations), an additional layer of tax called the generation-skipping transfer (GST) tax may apply at 40%.
And it’s important to keep in mind that today’s tax-free transfer amount is set to expire after 2025. That means it is possible that the amount you can transfer free of estate tax may be lower in the future. If a review of your plan reveals that you can afford to make gifts, it may make sense to make those gifts soon, while today’s record-high transfer tax exemption is in place.
Tax-Free Gifting Opportunities
The current tax law allows you to make certain gifts that don’t count against your gift and estate tax exemption amount. They also don’t require filing a gift tax return, so maximizing these “free” gifts is typically the first place to start with lifetime gifting.
Annual Exclusion Gifts
The annual exclusion allows you to make tax-free gifts up to a specified dollar amount to an unlimited number of individuals each year. For 2021, the annual exclusion amount is $15,000 for individuals and $30,000 for married couples. A couple with two children and three grandchildren would be able to make annual exclusions to each of them for a total $150,000 of tax-free gifts each year. At a 40% estate tax, that could be up to $60,000 of tax savings each year.
Over time, a regular practice of making these annual exclusion gifts each year can be very simple yet powerful tax-saving technique. It is also an effective way to gradually help children and grandchildren understand and appreciate their family’s wealth.
Medical and Educational Gifts
Another way to make tax-free gifts is to make direct payment for a child’s or grandchild’s medical or educational expenses. Payments made directly to a medical services provider (e.g., doctor, hospital) or to an educational institution for tuition are not treated as taxable gifts. Like the annual exclusion gifts, these payments do not use any of your gift and estate tax exemption and do not require the filing of a gift tax return.
While tax-free annual exclusion gifts and medical and educational payments are typically made to children and grandchildren, the same tax rules apply to gifts and payment for the benefit of other people, including children-in-law and grandchildren-in-law, parents, friends and other family members.
Making Larger Gifts
Large gifts typically can bring larger tax savings, but they also can come with a cost. If you make gifts above the annual exclusion amount, you will need to file a gift tax return, and these gifts will count toward your estate tax exemption amount. Once your estate tax exemption amount is reached, further gifts—either during your lifetime or at death—will be taxed at 40%.
But in appropriate circumstances, larger gifts can still yield large tax savings by:
- Removing future appreciation in the value of the gifted property from your estate.
- Enabling you to make use of a variety of gifting strategies and structures, such as qualified personal residence trusts, installment sales and gifts of partial interests that leverage actuarial factors and valuation considerations to achieve additional savings.
- Capitalizing on current gift and estate tax rules that make paying gift tax during your lifetime less expen-sive than paying estate tax at your death.
Giving cash or other assets that have little or no built-in gains is the most efficient way to gift during your lifetime. There are also techniques such as grantor retained annuity trusts and installment sales that can be structured to limit or even eliminate any negative gift tax consequences.
We can help you determine whether to make lifetime gifts, and help you make decisions about which assets to give first.
Cost Basis Step-Up: An Important Consideration
From a tax perspective, a downside of gifting assets during your lifetime is that assets that have appreciated in value do not receive a “step-up” income tax basis. Under today’s tax law, this means if you gift appreciated property or securities, the recipient will be subject to capital gains tax on the built-in appreciation when they sell the assets.
In contrast, unless the laws change, if your heirs inherit the property at your death, the cost basis will be “stepped up” to its then-current market value. Your heirs will only pay capital gains tax on any appreciation that occurs after they receive the property.
Due to this trade-off, it is important to run the numbers before making larger taxable gifts to decide which assets to give and when to give them. We can help you do the analysis to determine if larger gifts are right for you.
Strategies for Gifting to Children and Grandchildren
Many families still struggle with the practical implications of making lifetime gifts, even after they recognize the financial benefits. They are uncertain about giving a significant amount of property to a minor, who sometimes may only be an infant, or to a young adult still in the formative stages of developing a career, or even to a mature adult who may not be equipped to handle his or her own finances.
Fortunately, several savings vehicles and other structures provide the financial benefits of gifting while addressing these practical concerns.
529 College Savings Plans
A 529 College Savings Plan is like a retirement plan for education. The main advantage of a 529 plan is that the money grows in your account free of federal income tax. Under federal tax rules, the money must be used for qualified higher-education expenses, such as tuition, books and room and board. In addition, up to $10,000 a year can be used for tuition for K-12 education. If the money is used for other purposes, withdrawals are subject to income taxes and a 10% penalty on the earnings.
With a 529 plan, it is also possible to front-load five years of annual exclusion gift all at once and, for example, contribute $75,000 ($150,000 from a couple) to an account in year one rather than spreading the gifts over five years.
Uniform Transfer to Minor Act accounts are like normal individual bank or investment accounts, except for the fact that an adult custodian holds title and control of the account for the benefit of the minor until he or she reaches the age of 18 or 21. The downside of an UTMA account is that once the child reaches age 18 or 21, the account is transferred fully to the child and not restricted in any way.
The advantage of UTMA accounts is that they can hold any type of property and are relatively simple to create. For income tax purposes, property held in an UTMA account is treated as owned by the child, so earnings are generally taxed at the child’s—usually lower—tax rate, subject to the so-called “kiddie tax.” Since UTMAs are an asset of the child, they may negatively impact the child’s eligibility for financial aid.
For most families, lifetime gifts to children and grandchildren involve trusts. There is no restriction on the type of property that can be held in a trust. And trusts offer a great deal of flexibility as to when a child or grandchild ultimately will receive the benefits of the trust.
Special tax rules can enable you to make use of trusts in connection with annual exclusion gifts. These rules may require the beneficiary to have the power to withdraw trust property for a period (for example, 30 days after a contribution to the trust or after the beneficiary reaches the age of 21). If the annual exclusion is not a concern, the terms of a trust can be structured however you like.
Trusts do not provide the tax advantage of 529 plans in terms of providing tax-free growth, and like UTMAs, they can be considered as an asset of the child with respect to financial aid. But assets held in trust can be shielded from creditors and arguably provide the best way to ensure a family’s wealth remains with the family.
Delaware Dynasty Trusts
If you would like to secure assets for your family to benefit multiple generations, a Delaware dynasty trust can allow exactly that. A dynasty trust is designed to last in perpetuity with assets to be distributed to the beneficiaries in the future generations of your family based on the terms you define.
The trust is generally funded with an amount up to your maximum available generation-skipping transfer (GST) tax exemption. As a result, the trust property can pass from generation to generation, free of estate or GST tax.
Which Strategy Is Right for You?
If you believe your estate may exceed the estate tax exemption amount, you generally should consider making lifetime gifts. Annual exclusion gifts and payments of medical and educational expenses can provide easy tax savings, if you have cash or other property available to give.
If you are comfortable with a child or grandchild receiving assets when they reach the age of 18 or 21, you can make gifts to an UTMA account with little administrative hassle. If it seems likely they will need funds for college, it usually makes sense to take advantage of the tax incentives of 529 plans, including tax-free growth and the ability to front-load gifts.
Some families may stop at funding college and placing whatever they feel comfortable with a minor obtaining at age 18 or 21 in an UTMA account. But it is important to be aware that significant tax benefits can exist in making further gifts, and that trusts can be used to address many of the practical concerns as well as provide additional tax benefits, as with a Delaware dynasty trust or the tax planning opportunities involved in larger gifts.
Determining the strategies that will be the best fit for you will depend on your unique situation. Our trusts and estates advisors are always available to help you make the right choice in context of your goals and financial circumstances, and to make sure you’re surrounded by the right professionals to evaluate and implement your plans.