Gifting sounds pretty simple, but there are many ways to do it, and several tax ramifications to be aware of as well.
With any potential change in administration, wealth creation and preservation are hot topics of conversation. But this year, there’s one in particular that’s top of mind: the federal gift and estate tax exemption.
The Tax Cuts and Jobs Act significantly increased the lifetime gift, estate and generation-skipping tax exemption to $11.58 million per individual ($23.16 million per couple). The expansion was never designed to be permanent; the exemption is set to expire at the end of 2025. However, the possibility of a “blue wave” this election raises the likelihood that the expiration timeline could become significantly shortened, ending as early as 2021.
Suddenly, wealthy families are faced with the prospect of possibly losing an opportunity of transferring wealth out of their estate and saving on future estate taxes earlier than anticipated. The timeline may shorten to mere months, instead of the years they had originally planned for.
Regardless of whether a gift is made this year or down the road, here are some important questions to consider.
For couples with large taxable estates, gifting assets and removing future appreciation could yield substantial tax savings for their heirs. However, just because someone has the means to make a large gift doesn’t necessarily mean that it’s the right move: “Estate planning oneself into poverty” can be a real risk. Sometimes, families are so eager to take advantage of the tax benefits that they underestimate their own cost of living down the road and/or how long they’ll need their assets for.
First, it is important to assess if the grantor has sufficient assets to maintain their desired lifestyle. Then, consider how much can be passed without negatively impacting goals and lifestyle choices.
A question grantors grapple with is whether they should give away assets during their lifetime or at their death. Those who choose to gift while they’re alive often do so, not only to reduce their estate, but also to share in the joy in seeing the impact it makes in the lives of receivers.
Others prefer to gift after death for the security of having the assets on hand should they be needed. Gifting after death also allows for more time to prepare loved ones for the responsibility that comes along with inheriting wealth.
There are numerous ways of distributing assets, and what works for one family isn’t necessarily the best option for another. As a reminder, any transfer is gift tax-free up to the annual exclusion amount ($15,000 per person per donor for 2020). Any gift over this amount will count against the donor’s lifetime exemption amount. Once that lifetime exemption is exhausted, the gift will be subject to gift tax.
While this is likely the most uncomplicated way of gifting, for families of significant wealth, this approach could have some drawbacks related to the ability and experience receivers have to manage money, outside risks such as a spouse or high-risk professions, and demotivating recipients to live off their inheritance rather than becoming productive on their own. Given this, distributing large amounts of money, especially at a relatively young age, is generally discouraged.
Trusts are often used for larger gifts to provide for beneficiaries while using guardrails as restrictive or flexible as the grantor wishes, such as the following to protect the assets:
a. Distributing trust assets in stages: When the beneficiary reaches a certain age or achieves a specific goal, they receive an outright distribution. The advantage of this is that it allows heirs to “test the waters” in managing their wealth without putting all their inheritance at risk at once.
b. Leaving assets in a discretionary lifetime trust: This option would maintain the assets in a trust for the beneficiary’s entire lifetime. Drafted properly, this offers a high level of protection from divorcing spouses, lawsuits, bad decisions and outside influences. In addition, this could allow grantors to create a lasting family legacy for many generations. The downside of this is that the beneficiary could get frustrated about not having access to wealth easily and having to rely on a trustee’s discretion to make distributions. Clear instructions by the grantor to the trustee can help alleviate some of this.
Direct payments for education (such as college tuition) or for medical expenses have no gift tax consequences.
Educational gifts can also be made by funding a 529 plan. While there are no contribution limits for a 529 plan, gifts over the annual exclusion amount can have gift tax consequences or count against the lifetime exemption. There is also the option of making a larger tax-free gift to a 529 plan: You can pre-fund an account up to $75,000 and it will receive the same tax treatment as if it was gifted in $15,000 increments over five years.
These custodial accounts are generally less restrictive than trusts and allow minor beneficiaries access to funds at age a specific age depending on state of residence.
Inheritance is one of the few types of gifts that is generally not best left as a surprise. Families that keep beneficiaries in the dark about inheritance may cause many challenges down the road. Effective communication is essential — not necessarily about the amounts involved, but rather to make the intent and expectations of the grantor known. A financial adviser can be key in fostering these difficult conversations to ensure that beneficiaries are prepared to receive their gifts and be good stewards of family wealth.