If you want to leave your children a generous amount of money in your will, the federal estate tax may eat up a large chunk of their inheritance.
That tax only kicks in if your money and property — your “estate” — exceeds a certain amount, which the IRS adjusts each year based on inflation. For 2015, it’s $5.43 million per person, meaning any estates worth more than that will be taxed, up to a whopping 40%.
However, you can whittle down your estate by gifting some of that money tax-free while you’re alive. Even if you aren’t trying to minimize the effect of an estate tax, it’s nice to be around to see your kids enjoy whatever you’ve gifted them.
If you choose to start giving them money before your will kicks in, there are a few important things to know in order to maximize the amount you pass along:
You can gift $14,000 a year without declaring it to the IRS.
You can’t simply gift your kids an unlimited amount of tax-free money without reporting it to the IRS — a gift tax exists to discourage sheltering income in “gifts.”
The IRS determines a maximum amount that you can gift tax-free each year, and a maximum amount you can gift over your lifetime. For 2015, the yearly limit is $14,000 per person — an individual can give that amount to as many people as they want without declaring it to the IRS. That means a couple could pass on up to $28,000 a year to each child; or, if a couple has three grandchildren, the two together can make $28,000 gifts to each of them, for a total of $84,000.
The lifetime limit in 2015 is $5.43 million.
Note that if you gift more than $14,000 in a single year, you won’t necessarily be taxed — you just have to account for it, and file the appropriate forms, explains Michael Solari, a certified financial planner at Solari Financial Planning. This means that there will be more paperwork, and potential costs if you’re paying for someone to prepare your taxes.
You’ll want to keep track of how much you gift above the $14,000 limit though, as that amount will count against your $5.43 million lifetime limit. For example, if you gift your kid $25,000 one year, your lifetime amount will be reduced by $11,000 (the first $14,000 is ignored).
Also keep in mind that if you’re gifting your kid on an annual basis, they must cash or deposit the check that same year. So if the tradition is to give a check at Christmas time, make sure they take it to the bank before the new year. “Technically, they have to cash the check the year that they get the check,” explains John Gajkowski, a certified financial planner at Money Managers Financial. “And, if the husband and the wife are going to give $28,000 they should cut separate checks.”
You can give them more by using an educational savings plan.
If your main goal of gifting money to your kids is to cover education, consider contributing towards a 529 savings plan, a state-sponsored, tax-advantaged investment account that you can start when your child is born.
The cap of $14,000 per year, per child, and per donor still exists, but if you need to, you can front-load the account: You can give up to five years’ worth of contributions at once, or $70,000 per person, without triggering the gift tax.
“In year one of the plan, you might see a grandparent who has done really well for themselves and won’t need the money make this kind of contribution,” explains Michael Egan, certified financial planner and founding partner of Virginia-based financial planning firm Egan, Berger & Weiner. “It means they won’t be able to contribute for the next five years, but by putting the money in early, they’re giving it more time to compound, and they’re getting it out of their estate.”
Additionally, Coverdell Education Savings Accounts can be used to pay for K-12 schooling. It is important to note that with this account the total contributions are limited to $2,000 a year, and accounts are only available to couples with less than $220,000 (or individuals with less than $110,000) in annual income.
You can contribute to a Roth IRA on their behalf.
If your kid is working a part-time job, contributing to a Roth IRA on their behalf is one of the most effective strategies, explains Solari. Parents can contribute up to whatever their kid makes in income (up to the maximum yearly contribution of $5,500), and the money will grow tax-deferred. For example, if your kid earns $2,500 working a summer job, you could contribute $2,500 to their Roth IRA.
Note that these contributions count as part of the $14,000 that you can gift each year.
“It’s a really great way to get money into a Roth for your children at a very young age, and it’s a good way to start building up assets,” says Solari. Not only would you be jump starting their retirement fund, but you’d be instilling the importance of saving for retirement at a very young age
Plus, if your kid needs the money before retirement — for college or graduate school, for example — they can withdraw the contributions (not the earnings) penalty-free. “Have your kid put the money in and let it accumulate. When they need the money, they can take out the initial contributions and then just leave the earnings in there until they’re retired, which will then come out tax-free,” says Gajkowski. “It helps you do two things at once.”
Bear in mind that any withdrawals do keep their retirement savings from growing as quickly as they would if they were left alone, so you’ll want to make sure your children understand the consequences of dipping into these savings.
Beware the kiddie tax.
If you don’t like the idea of writing a massive check for your child each year, you can open a custodial account — a brokerage account that will be turned over to your kid at age 18 or 21, depending on the state you live in — and deposit money and assets on their behalf. This is also a smart way to introduce the concept of investing at an early age.
However, not all of the earnings will be tax-free, due to the “kiddie tax,” created to keep parents from sheltering income by putting accounts in the names of their lower-taxed kids. Basically, any unearned income — interest, dividends, and capital gains — will be taxed if it exceeds a certain amount. “The first $1,000 of earnings are tax-free, and then the earnings are taxed at the kid’s tax bracket,” explains Solari. “Once the earnings hit $2,000 or more, it’s taxed at whatever the parents’ marginal tax rate is.”
It’s also important to understand that once your kid reaches age 18 or 21, they have full control of the money. “The plus side of these accounts is that you get to build up some money and you get some tax advantages,” explains Gajkowski. “The disadvantage is that at age 18 or 21, it’s the kid’s money. They can do whatever they want with it.”
If you go this route, you’ll want to make sure your kid understands the basics of money management to ensure they’ll handle this money intelligently.