Tax-Free Wealth Transfers - The Basics

Start with Why: Why Transfer Wealth?

Gifting wealth during life to family members and loved ones can be a great thing and may occur for several reasons. For those with sufficient means and a well-designed financial plan, there may be the flexibility (and need) to transfer wealth to benefit others we care about.  Most often we transfer wealth to share what we have with those we care about DURING life to see them enjoy it (which is the focus of this article - testamentary transfers are not considered here). Money is complex however, and while those with the ability to do so want to share wealth with their family, it should be done thoughtfully and carefully. Transferring wealth without a plan can cause jealousy and infighting within a family - if not properly managed. An influx of money that was not “earned” can also cause a change in behavior and attitudes towards wealth or even false sense of security. Even when gifting wealth comes from a place of sincere love and generosity, to minimize the unintended consequences it should be done in a way that can work to fit each family’s unique dynamic and consistent with a real plan.

The most common reason to transfer wealth during life that we see are to support family members reach their goals. Common examples are supporting education, assisting with health care costs, paying for a wedding, assisting in the purchase of a home, providing funds to start a new business, helping someone afford a special vacation, and more.

A lesser considered reason is to potentially manage estate tax exposure, as gifts of wealth during life can help reduce the size of one’s ultimate estate. Many taxpayers are unfamiliar with the existence of the transfer-tax regime that can cause unnecessary tax compliance or liability if not properly navigated.  Helping those we love while also minimizing taxes is often an attractive reason to many to make gifts. However, if not properly managed, due to this tax system, our gifts can become less efficient. This short article is intended to provide general knowledge regarding a couple of basic lifetime wealth transfer strategies that can be used to share wealth with loved ones while avoiding the tax headaches.

Annual Exclusion Gifts

The most straightforward form of wealth transfer is direct gifting of cash or securities to loved ones.  In 2019, an individual can transfer up to $15,000 of value to another taxpayer without incurring a tax reporting obligation.  This $15,000 is what is referred to as the annual gift tax exclusion amount.  Therefore, if a single donor has 4 grandchildren, they could provide $15,000 to each for a total of $60,000 in a calendar year without facing transfer tax.

For a married couple, a strategy called “gift-splitting” can be used to double the exclusion amount. With gift-splitting one of the spouses uses the other’s $15,000 exclusion in addition to their own to benefit a single donee recipient.  The non-gifting spouse however would then not be able to gift to that same donee in the same tax year without then exceeding the annual exclusion limit. 

The annual exclusion amount only applies to gifts and transfers of a present or current interest. This essentially means the recipient donee must have immediate access to the acceptance, possession and enjoyment of the wealth being transferred to them for it to be considered a gift.  Gifts with certain strings attached or restrictions in place would generally not qualify for the exclusion. If a gift does not qualify for the exclusion or is a present interest transfer in excess of the exclusion amounts, the donor taxpayer(s) would have to file a gift tax return and based on their available unified estate and gift tax credit would potentially be liable to pay a federal (or state) transfer tax. The federal transfer tax system presently impacts only the wealthiest taxpayers with a tax liability, however even those making more modest gifts can be faced with a compliance/reporting burden if not careful.

Planning with the Annual Exclusion

Transferring cash is the most obvious and common use of a taxpayer’s annual exclusion. However, this does not mean that wealth transfers must be restricted to cash.  In fact, many taxpayers transfer other assets, such as securities.  For those with a certain mix of appreciated assets it may make more sense to transfer those appreciated securities to a loved one, rather than cash.  If certain rules are followed, it can be more advantageous for overall family wealth for those in a lower tax-bracket to realize gains and incur capital gains tax. Other forms of wealth (business interests, real property, etc.) can also be transferred using the annual exclusion. In these various instances, it makes sense to seek the guidance of a qualified financial and tax professional to optimize this strategy.

Aside from the form of wealth the annual exclusion can take, timing can also be essential. For instance, large milestone event gifting that may exceed the allowable annual exclusion may be better implemented around calendar year-end. If a two parents or grandparents want to make a one-time gift to a grandchild to help provide a down payment for their first home. The amount needed is undoubtedly going to exceed $15,000 or $30,000 in most cases. By making gifts around the end of the year, strategic gifting can provide a single donee with $60,000 (or more if a donee spouse is included) without tax implications. This same approach can be applied to other life events as well.

For those with means and looking to fund a 529 college savings plan there is a unique rule that can allow you to “super-fund” these savings through use of an annual exclusion. If funding a 529 plan, the donor can make five-years worth of annual exclusion gifts at once without tax implication. A gift-tax return must be filed for reporting purposes, but in one fell swoop a generous donor can benefit a loved one’s college funding to the tune of $75,000 in one year without incurring any gift tax liability or use of their exemption or credit. If two donors are involved and choose to gift-split, this funding amount could reach $150,000 without gift tax! The catch is that the donors may not make any additional gifts to the beneficiary for the five-year period beginning with the year of the gift without incurring gift tax. However, this strategy can be an exceptional way to fund a 529 plan at an early age, allowing it to grow over time. In some instances, the initial funding can grow tax-free and may not require any additional contributions to fund the donee’s entire educational cost.

Tax-Free Gifts Without Using the Annual Exclusion

Aside from direct gifts using the annual exclusion amount there are other ways to make tax-free gifts benefiting those we care about. The two most common are with regards to education and health care.  The Internal Revenue Code (IRC) permits transfers directly to qualifying educational institutions for tuition costs as well as direct transfers to qualifying medical institutions for health care - both without incurring gift-tax complications or obligations.  For these to be permissible, the transfers (payments) need to occur directly to the institution providing the education or health care and for the direct benefit of an individual. Therefore, if looking to benefit a loved one by paying for their education or health care costs, it is often best to pay those directly rather than providing the beneficiary with the funds to make those payments. Further, these transfers are unlimited without incurring a gift tax obligation (compliance or liability) and are not bound by the $15,000 annual exclusion limit for other cash gifts.  This is a useful strategy often times when college funding may fall short and gifts that grandmom and granddad would typically make could go directly to the schools.

Advanced Gifting

There are many other factors and scenarios that can complicate strategies for efficiently transferring wealth. The use of grantor retained annuity trusts, charitable trusts and certain testamentary trusts are used by high-net-worth families to efficiently transfer wealth by minimizing transfer taxes and thus maximizing family wealth retention. Additionally, those that are not U.S. citizens or residents may face additional/other rules than those articulated within this article. While we specialize in assisting with planning and management of these situations, the use of these trust techniques and consideration of non-U.S. citizens is beyond the scope of this discussion.

What we have touched on today are some of the most simple gifting strategies and can often be accomplished without the need for additional burdensome tax reporting. However, despite the relative simplicity of some wealth transfer strategies, most require consultation with a qualified financial, tax and legal professional to ensure proper implementation. There may be unintended consequences of gifting wealth without establishing a plan to manage the parameters involved. If you are interested in wealth transfer strategies we encourage you to contact us to learn more about how we may be able to assist. We can work with you and your family to develop a plan to meets your needs.

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