Tax-Efficient Family Gifting: An Advisor’s Guide

The line between taxes and financial behavior is very thin. Taxes give clues to other issues that might be going on beyond what goes on the tax return. Even though many of the answers are not tax-driven, the fact that financial planners are often viewed as trusted tax advisors (which in turn is often different from being the tax preparer) means they have the opportunity to learn where there are other questions that need to be addressed.

One of the most common tax questions advisors get from clients is some version of “How much can I gift to my kids without paying taxes?” Tax-savvy advisors know that the annual gifting limit in 2022 is $16,000 per giver/receiver, which can be doubled to $32,000 if the giver and/or receiver are married, and doubled again to $64,000 if both sides are married.

This of course is just the annual gifting limit. Going over this amount simply means that a taxpayer must file IRS Form 709 and start counting gifts against the lifetime giving allowance ($12,060,000 per taxpayer as of 2022).

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Savvy advisors also know that launching into the detailed numbers and thresholds is not the best starting place. When a client asks this question, the better starting point is “How much would you like to give?” The tax planning for gifting is drastically different when the answer is $5,000 versus $2 million in real estate.

The next question, which has nothing to do with taxes, is “What is your goal with this gift?” or “How will you know this gift was a success?” If the client is helping their child buy a house, the advisor can coach them on how the bank looks at gifts as part of a loan application, or in the event of funding retirement, advise on a traditional IRA versus a Roth. Either way, the key is to understand the “why” before jumping into the “how.”

Once the why is clearly established, there are strategies that can be considered beyond simply writing a check:

— Gifting appreciated assets.

— Using loans to accelerate gifts.

— Roth and gifting: Increasing the impact.

Gifting Appreciated Assets

Cash is not the only thing that can be gifted. Understanding this can be a powerful or a totally misguided strategy, depending on the situation.

Where it makes sense: When the client is in a higher tax bracket than the child and the client expects to live for many more years, gifting appreciated securities allows the child to sell them at a lower (or potentially 0%) capital gains rate. In this case, the tax rate arbitrage can be 23.8%, or higher once we account for shadow taxes.

Where it does not make sense: When the client is in a lower tax bracket than the child or the client has a limited life expectancy. In this case, gifting appreciated assets would not make sense, as the child would pay a higher rate, or the step-up in basis at death would eliminate the taxable gain.

Keep in mind that gifting is a very emotional decision, and as always, taxes are a passenger on the bus, not the driver. If the client insists on gifting a certain way, the advisor can encourage them to use a better tax strategy, but the primary goal is seldom tax optimization. As with any other tax strategy, advisors should help clients avoid derailing their retirement but not fight about their preferences if they will still be on track.

Using Loans to Accelerate Gifts

Let’s assume there is a married client who wants to give $500,000 to their married adult child. This might be to help purchase a home or start a business. Whatever the reason, the question comes up frequently. As already mentioned, the combination of two givers (parents) and two receivers (adult child and spouse) increases the combined annual limit in 2022 to $64,000. The best practice is to leave some wiggle room with the threshold in case of an IRS audit, so for this example, assume the couple is only going to be able to gift $60,000 annually without filing Form 709 and starting to use up the lifetime gifting limit.

One option, of course, would be to do a $60,000 gift each year for eight-plus years. This would get the $500,000 gifted without reducing the lifetime giving credit, but it does not help accomplish the original goal of being able to gift a large amount all at once.

Another would be to lend the $500,000 to the adult children on a 10-year term where each year the principal and interest payments would be forgiven as a gift. This would essentially allow the client to gift the $500,000 all at once but spread the accounting of that gift over whatever period of time is needed to stay under the annual gifting limit.

There are nuances to how this approach works, and record-keeping is key. This is definitely an area where partnering with a tax professional is going to greatly increase the likelihood of success.

Roth and Gifting: Increasing the Impact

A powerful strategy to discuss with clients interested in gifting is funding Roth accounts on behalf of children or grandchildren. To fund a Roth account, the recipient has to have earned income, but the actual source of the contributions can be from anywhere, including from gifts.

Here is an example of how this can be explained to clients:

One of the best ways to teach your child/grandchild the importance of saving for retirement is to help them max fund their Roth accounts each year. This way they can see the power of compounding growth on a meaningful amount of money. It is important to remember that this account belongs 100% to the child/grandchild and your control of the account is limited to encouragement. Typically, we have clients explain it to their child/grandchild as “I’m going to put money into this account each year for you, but the first time you take money out without my permission, my contributions stop.”

It bears repeating: Advisors have to get clear on the client’s goals before recommending any gifting strategies. If the client wants to help a child or grandchild with a down payment on a house or funding college that starts next year, Roth is not going to be an effective approach.

If, however, their goals are broader, this can be a powerful tool for building generational wealth and setting descendants up for success later in life. Tax-savvy advisors can easily help a client see the difference between simply giving $16,000 to a grandchild and helping them establish a Roth account that can grow tax-free for 40 or 50 or 60 years before it is needed.

Great tax planning requires understanding a client’s goals and knowing enough about the options available to them to point them in the right direction.

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