When an individual has reached a stage in life where they’ve begun thinking about how to pass their wealth to the next generation, it’s wise to consider how this can be achieved in a tax-efficient manner. Those who don’t think about this aspect of wealth transfer will likely see their estates paying significant estate taxes (up to 40% federally, plus state estate taxes, where applicable), which translates into a lot less for loved ones. Let’s walk through five tax-efficient ways to pass wealth to family or others.
- Annual Gifting
As of 2023, in general, the federal government allows individuals to give away up to $17,000 without paying any gift taxes – to as many recipients as a donor desires! So, for example, an individual may gift $17,000 to each of his/her three children this year for a total of $51,000 transferred tax-free. And, if desired, the individual’s spouse can follow suit, allowing the two of them to transfer a grand total of $102,000. These annual exclusion gifts must be of a present interest in the property and not a future gift.
- Lifetime Estate and Gift Tax Exemption
Gifts made beyond the annual gift tax exclusion (see #1 above) apply toward the donor’s lifetime estate and gift tax exemption. In 2023, this lifetime exemption is $12.92 million per individual (or $25.84 million for a married couple). This is the amount an individual may gift tax-free during his/her lifetime (over the annual gift tax exemption of $17,000 per donee). It should be noted that the large estate and gift tax exemption is applicable for all U.S. citizens and residents.
This means if an individual wants to give $20,000 to each of his/her three children, the first $17,000 of each present interest gift will be exempt due to the annual gift tax exclusion, and the remaining $3,000 will not be subject to tax because of the lifetime estate and gift tax exemption (assuming the individual has not yet hit the maximum of $12.92 million).
- Irrevocable Trusts
If an individual has reason to believe that he/she might exceed the lifetime estate and gift tax exemption, they should consider transferring wealth to an irrevocable trust. This can be done without incurring any gift taxes (i.e., using annual exclusions). Note, however, that the donor will lose control over the property once it has been transferred.
- Direct Payments
Another option is to pay for a loved one’s educational and medical expenses. Don’t confuse this with contributing to a 529 plan, however, which is considered a gift. In this case, a donor would send payments directly to the education or medical institution(s). (Be careful, though, because if a donor sends checks directly to an individual [e.g., a grandchild] to cover college tuition, for example, the gifts will be subject to gift taxes [assuming the gifts do not qualify for the annual exclusion]). Donors must pay the school directly. Thus, donors can pay as much of the educational or medical expenses (if qualified) as they desire and all without incurring any tax.
- Intra-Family Loans
If an individual wants to transfer wealth to a family member for a specific purpose (e.g., the purchase of a home, to start a business, or to pay down debt) and avoid hefty gift taxes at the same time, they should consider intra-family lending. The IRS offers a special interest rate for this type of loan that is typically lower than commercial rates. Individuals must be sure, however, to structure the loan according to IRS rules, so they don’t run afoul of any tax laws.
This design can run afoul of tax laws (e.g., Maxwell case) where the IRS argues a total gift from inception where an intent to repay is lacking. That is, forgiving the note/interest.
It’s apparent there are a number of different options to choose from when it comes to transferring generational wealth in a tax-efficient manner. Given the potential tax and legal considerations, however, it’s strongly advisable that individuals consult a trusted financial planner, tax expert, and/or attorney before making any of these financial moves.