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Thoughts for the Generationally Minded
What does it mean to be generationally minded? The definition we shall use is to long for your wealth to endure to your children and grandchildren. We keep in mind that we want our descendants to be productive and never to take wealth for granted, nor to consider themselves above others. This is a tall order, but with the right thought process, these goals can have a high probability of success. Transfers of wealth in this article is going to focus on gifts to children and grandchildren under 21 years of age.
First, we need to accumulate wealth in the most tax-efficient way for our children and grandchildren. Gifting is one way to do that for any family, but the complexity of gifting varies with the overall wealth of the family. Let’s make one thing clear: gifts are not income-taxable to your children. You can give your child $1 million, and there is no income tax. No income tax, but what about the maximum gift limit of $18,000 per person per year? That limit you hear about is very real, but the tax it references is the gift and estate tax. In 2023, there is a lifetime gift and death transfer limit of $13.61 million to a non-spouse beneficiary. If I give over $18,000 per person annually, then it begins to decrease my $13.61 million limit. Give your child $27,000, which is $10,000 more than the limit, and your lifetime exemption is now decreased by $10,000 to $13.60 million (though this illustration is simplistic, and the rules can be much more complex). Note that there is no actual cash tax owed; your lifetime transfer limit is simply decreased. When no monies on a gift and estate tax return are owed, there is no IRS penalty for not filing or late filing. Therefore, the decision as to when to file a gift tax return when gifts exceed the current gift exclusion of $18,000 should be made with your tax advisor.
The key to remember is there are no income tax issues with a gift of more than $18,000, and the tax for gifts more than $18,000 refers only to the gift and estate transfer tax limit on excess cumulative transfers during life and death of $13.61 million (current law will decrease this to $6.805 million in 2026). Families who never expect their lifetime estate to ever exceed $5 million can easily give gifts to whatever extent they desire without encountering much tax-related complexity. Families with an estate more than $5 million, however, need to be more thoughtful about how to make gifts, since their estate has a potential to be taxable upon their death. (The gift and estate tax rules discussed are based on 2023 rules and their accompanying sunset rules that come into effect in 2026. Congress may change these rules to any level they choose, and lower limits of $3.5 million have been proposed by current president Joe Biden.)
What are some great gifting strategies to enhance generational wealth? One of the best is funding a Roth IRA for the wages of your children and grandchildren no matter their age. Suppose your 16-year-old gets a job and earns $1,800 during the summer. You are allowed to place $1,800 into a custodial Roth IRA with you appointed as the custodian for your hard-working minor. You can fund any child or grandchild’s Roth IRA up to whichever is lower, their wages or $6,500. This is a top recommendation for the generationally minded.
If your child is on your high-deductible health insurance after college graduation and no longer a dependent on your tax return, then there is a great opportunity for the child to fund a Health Savings Account (HSA). The child who is no longer your dependent cannot use your HSA for their medical bills, but they can open their own HSA. The contribution for your single child is $8,300 for 2024. They get to use the family contribution limit of $8,300 because the HSA contribution rules are based on type of health insurance plan, family or single. This is also a top recommendation for the generationally minded.
Additionally, putting money into a 529 college savings plan is a gift, and you are allowed to give five years’ worth of gifts in one year. Giving to a 529 plan is a recommendation for generationally minded grandparents. Uniform transfer to minors’ accounts is merely a fancy term for an adult opening an account for someone under 18 years of age that cannot legally sign an account agreement. This form of gift opens the door for a wide range of uses for the monies to be used by the minor, and in most states, the minor controls the asset at 21 years of age to do as they please. Though the minor also controls the Roth custodial account at 21 years of age, there are many tax implications and requirements that can deter a young person from foolishly using the money.
Another device for gifting is the Grantor Living Trust. This concept is far too sophisticated and complex to be considered by anyone with less than $10 million net worth. The parent or grandparent makes gifts of either cash or assets into this vehicle. The preferable transfer is assets because they can bring forth preferential valuations compared to cash gifts. When assets are gifted and generate income and gains, the tax consequences revert to the grantor. It is best to see an example to understand the power of this technique. If $1 million is placed in the trust, every year the trust generates $50,000 plus of taxable income. The $50,000 of income every year is taxable to the parent or grandparent who originally donated the funds to the trust. In essence, the trust assets are growing tax-free, and the taxes paid by the grantor on behalf of the trust are not considered a gift. If the donor lives 25 years and pays $300,000 of taxes over 25 years, legally it is not a gift to the trust, because the IRS is the one who created the rules, making income reportable on the grantor’s tax return. These grantor trusts come in many sizes and shapes and for different purposes, but they are all very effective for the high-net-worth client.
Another great wealth transfer strategy for the generationally minded is to own a business and employ your children or grandchildren. The most important point is that your minor must work to earn the funds they receive. The business owner parent can pay a child more for services than they may imagine. The use of your children’s photos on your website can be paid a salary. No accountant should sign off on a tax return where minors were paid knowing no work was completed. Salaries of $12,000 are federally tax free and in some cases up to $40,000 can be 100% income tax-free depending on use of HSAs, retirement accounts, and college education credits. The salary will be taxable for Social Security and Medicare in corporations and partnerships and tax free for FICA taxes in sole proprietorships and parent-owned partnerships when the minor is under 18 years of age. Salary wealth transfer is an excellent strategy for the generationally minded parent or grandparent. It opens the door to substantial tax-free income which can then fund HSAs, Roth IRAs, and Roth 401ks.
These are just a few of the generational wealth transfers with exceptional tax advantages. There are others, and many of them work with parents in a lower income tax bracket.
When we transfer wealth to the younger generations, it is important that we do so without creating dependency on the family wealth. There is no magic formula, for what works with one child may not work with another. It is important to assess how small gifts are used and appreciated. Is there a future expectation, and what are they doing to further their own long-term contribution to mankind? The greatest legacy we can leave behind is to inspire in the next generation an eager aspiration to give their all back to their family and community.
If you are in a higher income tax bracket and in need of a tax-efficient wealth transfer technique to children or parents, contact your Consulate Advisor to help you develop your best tax strategy and remain cognizant of ensuring your gifts have a long-term positive impact.
Financial Consulate aims to help lessen the worry and burden of wealth management and enhance financial wellness so our clients can pursue relationships and true fulfillment. Choose the professionals at Financial Consulate as your Certified Financial Planners™ (CFP®) to take advantage of our educational, ethical approach to financial planning. Our services are comprehensive, including tax planning, investment planning, retirement planning, estate planning, and more. We operate completely independently and offer fee-only services to keep your vision in line with our recommendations at all times. While we have offices in Hunt Valley, Maryland, Fernandina Beach, Florida, and Gettysburg, Pennsylvania, we serve clients across the nation. To begin your partnership with a trustworthy wealth advisor, please contact Financial Consulate today.