One of the questions I receive most frequently from Retirement Watch subscribers is how to make estate planning gifts. Let’s take a look at the issues that recur among many readers.
Gifts to family members are one of the staples of estate planning. But the tax law has changed, and that’s altered the role of gifts and strategies about giving. Here’s what you need to know about estate planning gifts to children and grandchildren in light of the Tax Cuts and Jobs Act.
Back before the 2001 tax law, when even most middle-class families were subject to the estate tax, annual estate planning gifts were common. People were counseled to remove some wealth tax-free from their estates each year because their estates were likely to be taxed. Now, only the very wealthy need to consider gifts as an estate tax reduction strategy. The rest of us should consider the non-tax reasons for making gifts and use them to develop a giving plan.
Who should consider lifetime gifts? Rule #1 about estate planning gifts is to retain enough assets and sources of income to ensure your financial security. Among the most common reasons for running out of money in retirement are that people helped their children and grandchildren too much or they didn’t have enough money to pay unexpected medical or long-term care expenses. Before making lifetime gifts to children and grandchildren, ensure you are financially secure under even pessimistic scenarios and have a plan to cover any long-term care needs.
Why make lifetime gifts? Let me emphasize again that you shouldn’t make lifetime gifts that might put your financial independence in doubt after considering bad-case scenarios. When you’re financially secure, however, there are several advantages to lifetime gifts.
Your children might be able to make good use of the money now, instead of waiting until some unknown time in the future when they inherit. Perhaps they could make a down payment on a home, repay some debt, or give their children better educations. Maybe the extra money could make some small improvements in their lives, such as allowing them to replace some furniture or take a family vacation. The possible uses of the gifts depend on your family.
Lifetime gifts also help you. You’ll see how the children use the gifts. The gifts also give you an opportunity to provide some education and advice about money and its uses. Your children also might learn more about money. Perhaps they’ll spend the first gift and then, after a time, will begin to realize they could have made better long-term use of it.
Their own experience, plus advice they receive from you (and perhaps your financial advisors), might help them better manage future gifts and the eventual inheritance.
I hear from many people who are concerned that leaving their children a lot of money will ruin them. Annual gifts are a good way to see if that’s true and also have the children get used to handling wealth. Large inheritances usually ruin the heirs when they don’t have the knowledge to manage it or aren’t mentally and emotionally prepared. Sudden wealth tends to cause problems.
Lifetime gifts also can help you clarify what you ultimately want your wealth to do and the best ways to transfer it to the next generation.
When should gift giving begin? In general, this is an easy question, but it’s harder to answer in specific cases. The real question people are asking is how do they know the children won’t waste the money or it won’t ruin them?
The general answer is you want to consider lifetime gifts when the children are financially responsible. Sometimes you know whether or not a child is financially responsible and what he or she is likely to do with wealth. Often, you don’t.
That’s one reason it’s important to consider lifetime gifts. You’ll see how the children handle the gifts. They’ll also have an opportunity to learn about money. No doubt you made some mistakes with money over the years. But since you have enough to consider lifetime giving, you learned how to manage it well. Lifetime gifts provide your children the same opportunity to learn. The earlier you begin giving, the more comfortable they can become with money, and the more comfortable you might become that they’ll be able to handle larger amounts.
Sometimes parents aren’t sure whether one or more children are financially responsible, but they still want to help them. Then, you want to consider the next question.
How should I make gifts? Direct gifts of money aren’t the only way to make gifts. You can give property instead of cash, and you also can give through trusts.
One of my favorite books is the classic, “The Millionaire Next Door,” by Thomas J. Stanley and William D. Danko. In it, the authors discuss a study they did on gift giving. They found that cash gifts often were spent quickly. More importantly, recipients of cash gifts often had smaller nest eggs when they reached retirement age than peers who hadn’t received such gifts. It seems that if you prefer that the gifts not be spent and your goal is to increase financial security, you should give property instead of cash or make gifts through trusts.
Trusts are very flexible. They can have as few or as many restrictions as you want. A widely used trust pays income to the beneficiary each year and makes distributions of a portion of the principal at different ages, such as 35, 40 and 45. Then, the remaining trust principal is distributed.
But there is a wide range of other possibilities. At the other extreme, the trustee has discretion over distributions of income and principal. The trustee monitors how the beneficiary spends money to determine whether to distribute money or retain it in the trust.
Some trusts make distributions when the beneficiary achieves certain milestones. A milestone can be turning a certain age. Or milestones can be achievements, such as graduating from college, holding a job for a period of years, or whatever you want to name.
A trust, of course, incurs additional costs both in creating it and in annual management. It also might pay higher income taxes than an individual would. But those are the costs of protecting the assets. You and your estate planner can discuss which trust provisions might achieve your goals.
Should gifts be equal? When there’s more than one child, parents often wonder if they should give equal amounts to them. The best answer depends on both the children and the family relationships. Often, family relationships will be irreparably damaged if the children aren’t treated equally. But sometimes unequal gifts are acceptable by all when one child has been much more successful financially. Of course, giving more to a special needs child usually is accepted. When the reason to consider unequal gifts is that a child is more likely to waste the money, first consider giving through a trust.
A family business often requires unequal gifts when the children have unequal participation. Leaving equal shares of the business often doesn’t work when some children are involved in the business and contribute to its success while the others don’t. Common disputes include whether the uninvolved children are qualified to help make decisions about the business and whether the income of the business is to be reinvested or distributed.
When unequal gifts are going to be made, the reasons for doing so need to be explained to all the children.
What about giving to charity? You can give to both your children and charity, such as through a charitable remainder trust.
Suppose you have appreciated property worth $250,000. You paid $50,000 for it and don’t want to pay capital gains taxes on the sale. You can donate the property to a charitable remainder trust that will pay income to your children for a period of years or for their lives. After that time, a charity is paid the remainder of the trust.
Let’s say you schedule the trust to pay 6% of the trust value to the children annually for 20 years. You’ll receive an income tax deduction of about $75,000 and won’t owe any capital gains taxes on the appreciation. Your children will receive 6% of the trust value each year for 20 years. If the trust earns an average investment return, the children will receive a total of $330,000 over 20 years, and a charity eventually will receive more than $300,000.
Whether to give wealth now or later is a difficult question for many people. This guide should make the decisions easier for you.