Most parents prioritize generosity, responsibility and fairness when it comes to giving money and passing on wealth to their children and grandchildren. But, particularly in cases where there are substantial family resources, being strategic about giving also can be important.
Determining the best way to pass money to your heirs largely depends on the ages of your children and your objectives, said Shilpa Mirchandani, a senior wealth planner with City National Bank in Beverly Hills.
“It's important to understand what the family wants to accomplish, such as funding for education, leaving an inheritance or protecting assets, and to determine the best timing for those goals," said Mirchandani. “For example, the family may want to set aside a certain sum today but intend for it to be used at some point in the future."
While one main goal of passing down wealth may be to provide financial support for the family for generations to come, families should understand the tax implications of such giving in order to achieve their long-term wealth plans.
It is important to note gifts of money or property may be subject to federal gift or estate tax, depending on the value of the gift and the way it is given. If tax liability is incurred, it is the donor - not the recipient - who pays the tax. Estate tax, if required, is typically paid from the deceased donor's estate.
The current top federal estate and gift tax rate is 40 percent. Gift tax is applied during the donor's lifetime while estate tax is imposed upon the donor's death.
Gifts from a donor in excess of $15,000 within one year must be reported to the IRS using Form 709, even if the donor has not exhausted his or her lifetime gift tax exemption.
In 2021, the lifetime gift tax exemption is $11.7 million. The IRS will use the information reported on Form 709 to update the donor's remaining gift tax exemption and determine whether federal estate taxes are due after the donor passes away. IRS Form 706 addresses federal estate taxes upon an individual's death.
Some states also impose state gift or estate taxes, which may apply in addition to the federal tax.
“Estate planners can establish trusts in different states to take advantage of favorable jurisdictions," said Joe Goldman, a trust advisor with City National Bank in Beverly Hills. “In addition to having different income tax rates, states have various rules about how long a trust can last. For example, in California, a trust may only last a limited period of time, but in Delaware, a trust can be set up to last indefinitely."
Twelve states and the District of Columbia currently collect estate taxes on residents, according to NerdWallet, with exemption levels ranging from $1 million to $5.74 million.
A 529 plan is a tax-advantaged investment account designed to encourage college savings. Whether you want to fund a private education throughout your child's lifetime or pay for higher education, a 529 education savings account could be a powerful option, said Mirchandani.
Anyone can open a 529 savings account on behalf of a beneficiary, but typically they're opened by parents or grandparents.
The funds in the account grow tax-deferred and, as long as the funds are used for qualified educational expenses, such as tuition, books, supplies and room and board, withdrawals are tax-free.
There are many 529 programs that are administered by state governments with varied rules. For instance, some states provide a state income tax deduction or credit for 529 contributions.
And while annual contributions to 529 plans are unlimited, they also are subject to gift tax rules. Each state sets an aggregate limit for 529 plan balances.
In California, for example, the aggregate 529 plan balance limit is $529,000. “Donors can gift up to $15,000 each year to each beneficiary under the annual gift tax exclusion, including into a college savings fund for that beneficiary," said Mirchandani. “Each donor can give that much to a descendant, so a married couple can contribute $30,000 per child or grandchild to a 529 plan in one year, tax-free."
In addition, contributions to a 529 plan can be frontloaded by gifting five years' worth of annual exclusion gifts at once without impacting the gift tax exclusion, said Mirchandani. Thus, you and your spouse can open a 529 account for a child or grandchild and immediately contribute up to $150,000 as annual exclusion gifts.
“Frontloading the plan, especially if your child is young, offers the advantage of giving the money more time to grow," said Mirchandani. “At the same time, you're potentially pulling that money out of your taxable estate."
For example, Mirchandani said grandparents with five grandchildren could deposit $150,000 each, per grandchild, and thus reduce their estate by $750,000 without any impact on their gift tax exemption.
The funds in a 529 plan may be used to pay for college or graduate school. In addition, up to $10,000 per year can be withdrawn tax-free to pay elementary, middle and high school tuition at private and parochial schools.
In addition to funding a 529 tuition plan, there are additional tax-advantaged ways to provide funds to your descendants, including giving to:
Note sometimes people erroneously think that adding their adult children's names to their bank accounts can be a way to avoid estate or gift taxes, and this is not necessarily the case.
“While that might seem like a simple thing to do, adding your adult child's name to your accounts would count as a gift," said Mirchandani. “If you're audited, then that would count against your gift tax exemption."
In addition, Mirchandani explained, once a child is added as a joint owner to an account, he or she can withdraw some or all of the account, or the account may be subject to the child's creditors. If the child goes through a divorce, the account may be included as part of the child's overall assets. If the child were to die, the account would potentially be included in the child's estate.
Trusts can be written for minors or for adults, with the distribution of funds outlined in the trust agreement.
“A trust is a good vehicle to clearly establish your intent for your gift while also functioning as a means to reduce the size of your taxable estate for the future," said Mirchandani. “You can limit distributions to pay for education or health care needs, or you can establish a timeline for distributions based on age or specific events, such as purchasing a home or starting a business," she said.
Based on the client's goals and circumstances, there are a variety of techniques that a client can consider with his or her tax, legal and other advisors. The options most commonly used today are the:
With this type of trust, you may sell assets to the trust in exchange for a promissory note that pays market-rate interest. The strategy is most effective when the trust assets appreciate at a rate that exceeds the applicable interest rate.
“The IDGT makes a lot of sense if the asset is expected to appreciate, such as stock in the family business that is anticipated to be sold someday," said Mirchandani. “The trust can sell the assets to a third-party buyer and the proceeds can be retained and distributed per the trust's terms."
In a low-interest rate environment, or when an asset such as stocks are depressed in value, a GRAT can be an opportunity to make a gift at a low tax cost that will appreciate for your beneficiaries.
An additional 40 percent generation-skipping transfer (GST) tax may be imposed on gifts or inheritances transferred to a skip person, such as a grandchild or unrelated individual that is at least 37 ½ years younger than the donor, said Mirchandani.
Similar to the federal estate tax exemption, a donor can use his or her federal GST tax exemption ($11.7 million in 2021) when making gifts to skip persons.
Purposeful planning is an approach to estate planning that involves all the beneficiaries and improves the possibility that wealth will last for multiple generations.
"An important element of gifting money to children is to prepare them to manage their gifts," said Goldman. “You can set up all the sophisticated trusts you want, but if future generations are not prepared to handle the money, then the benefit of the wealth could be lost."
This type of planning includes financial literacy training and discussions of goals and values among all family members. Philanthropy and the responsibility of wealth management are typically part of the discussion as well.
“Gifting money in your lifetime rather than through your estate has multiple benefits," said Mirchandani. “The assets can appreciate for more time - which is good for your beneficiaries - and you're moving the money out of your taxable estate. It's also an opportunity to discuss your values and teach your children and grandchildren how to manage their wealth."
With the expertise of wealth and estate planners, sharing the wealth with your descendants can establish a foundation of financial stability for generations.
Need to discuss your wealth plan with an advisor and wish to find one? Get in touch with a City National advisor today.
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This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.
City National, as a matter of policy, does not give tax, accounting, regulatory or legal advice. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. You should consult with your other advisors on the tax, accounting and legal implications of actions you may take based on any strategies presented, taking into account your own particular circumstances.