If some congressmen had their way, you would be able to pass on such genetic traits as hair and eye color-and little else.
Lately, members of Congress looking to cut the $322 billion federal budget deficit have been studying a variety of estate- and gift-tax increases ranging from restricting the annual maximum amount of tax-free gifts to lowering the $600,000 lifetime exemption from federal estate taxes, whose top rate is 50 percent.
Just the hint of such changes has spawned a wave of seminars by insurance agents and estate planners on how to keep your estate taxes low.
So now may be the time for the prudent parent to consider the Tax Theory of Relativity: the proposition that it is better to give to your real relatives than to Uncle Sam.
You will save two ways: by shifting income-producing assets to family members in lower tax brackets and by substantially reducing the size of your estate, and thus your estate taxes.
Here are six ways to turn money over to your kids, starting with the easiest:
– Outright gifts: You and your spouse may make annual tax-free gifts of up to $10,000 apiece-a combined $20,000-to as many recipients as you wish. In addition, the estate- and gift-tax law gives each of you a lifetime exemption of $600,000 on transfers made by gift or by will. There is no limit on gifts for a relative’s tuition or medical expenses, however, but the money must be paid directly to the school or health-care provider. Keep in mind, however, that if you make an outright gift, your child will immediately be free to do with it as he or she pleases.
Undeniably, giving money to your kids won’t be the tax saver it was before the ’86 tax reform law. Reform made your child’s investment income above $1,200 taxable at your top rate if he or she is under 14; it also narrowed the spread between the lowest and highest tax brackets, further reducing your potential savings. But the strategy of shifting income to your child will deserve a fresh look if Congress, as expected, raises the top tax rate to 39.6 percent this year.
– Custodian accounts: When you want to transfer legal title to an asset to a young child now for his or her use later because the child is too young to manage it, the simplest route is setting up a custodian account through the Uniform Gifts to Minors Act (UGMA, applicable in 20 states) or the Uniform Transfer to Minors Act (UTMA, in the other 30 states and Washington, D.C.).
Under these laws, you open a bank or brokerage account in your child’s name and appoint a custodian to administer it until the youngster reaches age 18 (generally 21 under UTMA). Transfers of property under UGMA or UTMA qualify for the $10,000/$20,000 annual gift-tax exclusion, even though your child can’t use the gift until age 18 or 21.
A couple of tips: Put stocks or mutual funds with growth potential into these accounts. By handing over, say, high-tech stock worth $20,000 today, you could be removing $100,000 from your future estate. And don’t name yourself custodian of your own gifts. If you do and die before your child becomes an adult, the value of your gift will be taxed as part of your estate. Name your spouse as custodian instead. If you and your spouse will make the gift jointly, consider a third-party custodian.
– Children’s trusts: Only two types of trusts-a minor’s and a Crummey-qualify for the $10,000/$20,000 annual gift-tax exclusion. In a minor’s, or 2503(c) trust, the trustee (normally you) controls the income and principal until your child turns 21. A Crummey trust is more tight-fisted. The principal belongs to your child at age 21, but he can’t take the money and run. Instead, he or she can withdraw a limited amount each year, a sum determined by you when you create the trust. If your child dies before 21, the funds go to his or her estate.
An appealing note: The first $100 of trust income is tax-free, and the next $3,750 is taxed at 15 percent, regardless of your child’s age. After that, income between $3,750 and $11,250 is taxed at 28 percent and above that, 31 percent. Under the proposed new rates, the numbers get noticeably harsher: The tax rate on the first $1,500 would be 15 percent; up to $3,500, 28 percent; up to $5,500, 31 percent; up to $7,500, 36 percent; and over $7,500, 39.6 percent. You will need a lawyer to set up a trust, so unless you plan to transfer assets of more than $50,000, it’s not worth it to fork over the $1,000 to $1,500 you can expect to pay in legal fees.
– Interest-free loans: These loans are useful if you want to make a short-term gift to your adult child and get the principal back without the legal acrobatics of a trust. No-interest loans of $10,000 or less are exempt from gift tax unless used to purchase income-producing property, such as rental real estate. The same is true for interest-free loans of up to $100,000 if your child’s net investment income for the year is $1,000 or less.
If your loan doesn’t meet either of these criteria, the foregone interest on it is subject to gift tax. Foregone interest is the amount you would have collected if you had charged a rate-currently 3.62 percent for loans shorter than three years, 5.33 percent for loans of three to nine years and 6.47 percent for longer loans-set by the federal government. Make sure you have all the loan’s terms in writing or the IRS may treat the entire transaction as a gift.
– Family limited partnerships: One of the hottest current estate-planning techniques is setting up a parent-child partnership, with you as the general partner. You and your spouse can then transfer to each of your children an interest in your home or business worth up to $20,000 every year. Such partnerships let you keep property out of your child’s hands until you think he or she is ready to handle it. Lawyers typically charge $400 to $1,000 to establish a partnership.
– GRITs: If your and your spouse’s estates will together exceed $1.2 million (your combined lifetime exemption), consider a grantor retained income trust (GRIT). You can put your home in an irrevocable GRIT, reserving the right to live there for, say, 10 years. When the trust ends, your child gets the house. If you don’t want to move when the GRIT expires, your child could then rent the home to you at a market rate.
What makes a GRIT so appealing is that the transfer is valued at only a fraction of what your home is currently worth, because your child has to wait to get it. For example, if you put your house, now worth $350,000, in a 10-year GRIT and you are 50 years old, its present value according to IRS tables is $172,165. By making the transfer, you will use up only that much of your lifetime exemption, instead of $350,000. Expect to pay an estate lawyer $1,500 to $2,000 to set up a GRIT.
There is one big drawback, however: If you move out or die before the trust ends, the assets will be included in your estate. Then your heirs will just have to grit and bear it.
