Strategies to help you transfer your wealth
Individuals with significant assets who want to transfer wealth to heirs tax-free, as well as minimize estate taxes, should take advantage of proven tax strategies such as gifting and direct payments to educational institutions; however low interest rates and a volatile stock market are creating additional opportunities. Let’s take a look at some of the strategies available:
Use the Annual Gift Tax Exclusion
The annual gift tax exclusion provides a simple, effective way of cutting estate taxes and shifting income to heirs. For example, in 2020, you can make annual gifts of up to $15,000 to as many donees as you desire. The $15,000 is excluded from the federal gift tax so that you will not incur gift tax liability. The annual exclusion applies to gifts to each donee. Furthermore, each $15,000 you give away during your lifetime reduces your estate for federal estate tax purposes. Any amounts above this limit, however, will reduce an individual’s federal lifetime exemption and require filing a gift tax return.
If you’ve given money or property to someone as a gift, you may owe federal gift tax. Many gifts are not subject to the gift tax, but there are exceptions. Because gift tax laws can be confusing, below are some tips you can use to figure out whether it is taxable.
The general rule is that any gift is a taxable gift. However, there are many exceptions to this rule. For example, the following gifts are not taxable:
- gifts that do not exceed the annual exclusion for the calendar year, ($15,000 for 2020)
- Tuition or medical expenses you pay directly to a medical or educational institution for someone,
- gifts to your spouse,
- gifts to a political organization for its use, and/or to charities.
Gift tax returns do not need to be filed unless you give someone, other than your spouse, money or property worth more than the annual exclusion for that year.
You and your spouse can make a gift of up to $30,000 to a third party without making a taxable gift. The gift can be considered as made one-half by you and one-half by your spouse. If you split a gift you made, you must file a gift tax return to show that you and your spouse agree to use gift splitting.
Making a gift does not ordinarily affect your federal income tax. You cannot deduct the value of gifts you make (other than deductible charitable contributions).
Make Direct Payments to Institutions
Direct payments for medical or educational purposes indirectly shift income to heirs; however, it only works if the payments are made directly to the qualifying educational institution or medical provider. This strategy allows you to give more than the annual gifting limit of $15,000 per donee. For example, if you’re a grandparent, you can pay tuition directly to your grandchild’s boarding school, college, or university. Room and board, books, supplies, or other non-tuition expenses are not covered. Likewise, in the case of direct payments to a hospital or medical provider. Medical expenses reimbursed by insurance are not covered, however.
Loans to Family Members
Offering to lend money to cash-strapped friends or family members during tough economic times is a kind and generous offer, but before you hand over the cash, you need to plan ahead to avoid tax complications for yourself down the road.
Take a look at this example: Let’s say you decide to loan $5,000 to your daughter who’s been out of work for over a year and is having difficulty keeping up with the mortgage payments on her condo. While you may want to charge an interest rate of zero percent, you should consider the following: When you make an interest-free loan to someone, you will be subject to “below-market interest rules.” IRS rules state that you need to calculate imaginary interest payments from the borrower. These imaginary interest payments are then payable to you, and you will need to pay taxes on these interest payments when you file a tax return. To complicate matters further, if the imaginary interest payments exceed $15,000 for the year, there may be adverse gift and estate tax consequences.
Exception the 10,000 loophole: The IRS lets you ignore the rules for small loans ($10,000 or less), as long as the aggregate loan amounts to a single borrower are less than $10,000, and the borrower doesn’t use the loan proceeds to buy or carry income-producing assets.
As was mentioned above, if you don’t charge any interest, or charge interest that is below market rate (more on this below), then the IRS might consider your loan a gift, especially if there is no formal documentation (i.e., written agreement with payment schedule) and the IRS decides to audit you and decides your loan is really a gift. Formal documentation generally refers to a written promissory note that includes the interest rate, a repayment schedule showing dates and amounts for all principal and interest, and security or collateral for the loan, such as a residence (see below). Make sure that all parties sign the note so that it’s legally binding.
As long as you charge an interest rate that is at least equal to the applicable federal rate (AFR) approved by the Internal Revenue Service, you can avoid tax complications and unfavorable tax consequences. AFRs for term loans, that is, loans with a defined repayment schedule, are updated monthly by the IRS and published in the IRS Bulletin. AFRs are based on the bond market, which changes frequently. For term loans, use the AFR published in the same month that you make the loan. The AFR is a fixed rate for the duration of the loan. Any interest income that you make from the term loan is included on your Form 1040. In general, the borrower, who in this example is your daughter, cannot deduct interest paid, but there is one exception: if the loan is secured by her home, then the interest can be deducted as qualified residence interest–as long as the promissory note for the loan was secured by the residence.
This strategy works by loaning cash to family members at low interest rates, which is then invested with the goal of reaping significant profits down the road. With mid and long-term applicable federal rates (AFR) rates for June 2020, as low as 0.43 and 1.01 percent, respectively, heirs can lock in these rates for many years – three to nine years (mid-term) and nine to more than 20 years (long-term).
Grantor Retained Annuity Trust (GRAT)
Another relatively low-risk strategy is the grantor retained annuity trust (GRAT), where the donor transfers assets to an irrevocable trust and receives an annuity payment back from the trust each year. This strategy enables heirs to profit from their investments long-term – as long as returns are higher than the IRS interest rate. This is easier than ever now that IRS interest rates are so low. In June 2020, the interest rate used to value certain charitable interests in trusts such as the GRAT is 0.60 percent.
Roth IRA Conversions
Contributions to a traditional IRA are made pre-tax, which means distributions are considered taxable income; however, with a Roth IRA, the tax is paid upfront, and distributions are completely exempt from income tax. It is this feature that makes converting a traditional IRA to Roth IRA and rolling it over to an heir an attractive option, especially during a financial crisis. The conversion is treated as a rollover, and typically would be accomplished via a trustee to trustee transfer where the trustee of the traditional IRA is directed to transfer an amount from the traditional IRA to the trustee of the Roth IRA. The account owner pays income tax on the amount rolled over in the year the account is converted, which allows the account to accumulate assets tax-free and future distributions are tax-free.