It’s that time of year again. Not only is Santa Claus coming to town, but the kids and grandchildren as well. In the spirit of St. Nick, do you know what your clients’ year-end gifting plans are? If not, now is an excellent time to approach the subject of charitable gifting with each of your affluent clients. With the repeal of the estate tax still in flux, your affluent clients should be employing gifting strategies to reduce their overall estate tax burdens. There is no guarantee the estate tax repeal will be made permanent or that it will even occur in 2010 (the Democrats’ ascendancy in Congress following last month’s mid-term elections makes permanent repeal anytime soon even more dubious), or that a given client would survive until 2010. So, if you are not addressing this issue, your clients may miss out on effective ways to transfer wealth to their families or charities.
Let Me Count the Ways
There are a variety of ways for your clients to gift. Many individuals prefer to make outright gifts; others find it advantageous to make gifts by retaining an interest so that an income stream is created for them for a specified period of time.
But, as with any financial planning strategy, understanding your clients’ specific objectives is crucial. To understand your clients’ current objectives and the solutions that would best fit their needs, you could use the following four questions to draw that information from them:
1. Why do you want to make this gift? Is it because you wish to:
- Reduce potential estate tax
- Help someone achieve a specific goal
- Leave a legacy
2. When do you want to make the gift?
- Over the course of a lifetime
- Upon death
- Combination of the two
3. How much do you want to gift?
- 100% of value
- A specific amount
4. How much control do you want to retain?
- Outright gift (relinquish all control)
- Place in a trust or some other financial structure (which allows for some donor control)
As you are well aware, for a transfer to be considered a gift requires that the donor let go of control of the assets. To help your clients avoid gifting remorse, make sure they are comfortable with the amount they have in assets and can afford to gift. Many people do not gift because they believe they are unable to afford it. Alternately, they may shy away from gifting because they do not fully understand the tax benefits, deductions, or when they may need to file the appropriate return. (See “Filing a Gift Tax Return” sidebar.)
Affluent clients may believe that they need to keep all their assets available to ensure care for themselves through an extended retirement or in case of serious illness. You will need to encourage such clients by illustrating how gifting strategies may benefit them, including estate tax savings, and the probability of achieving all of their goals with a gifting plan in place.
Gifting for the Tax Benefit
The definition of a gift is pretty simple: a gift is giving property (including money) or the use of or income from property, without expecting to receive something of at least equal value in return. If donors sell something at less than its full value or make an interest-free or reduced-interest loan, they may be making a gift.
So often we get caught up with impressing our clients with our sophisticated knowledge that we forget about addressing the basics. Many times, it turns out, the simplest strategies are the most effective. With that in mind, let’s focus our conversation on the basics of gift giving.
For 2006 and 2007, the annual exclusion is $12,000 (in 2006, gift splitting allows married couples to give up to $24,000 to a person without making a taxable gift). Many times, our clients wait until year-end to give gifts. To enhance gifting, you may want to discuss giving gifts at the beginning of the year instead, which allows your clients to get the appreciation on that asset removed from the estate for the entire year. Keep in mind that the gift of a check is effective on the date the donor gives the check to the recipient, and the donor must still be alive when the donor’s bank pays the check.
Another way for clients to get appreciation out of the estate is to gift assets that may appreciate significantly over time. This way, your client can use the annual exclusion to gift an asset that may be worth much more than the exclusion amount at a later date.
Now more than ever, with the Tax Increase Prevention and Reconciliation Act of 2006, it is important to think about what and to whom one is gifting. Shifting strategies may not be as powerful as they once were. For example, under the new law, all children up to the age of 18 (as opposed to 14) are subject to be taxed at the parents’ rate (retroactive to January 1, 2006).
Under a provision known as the “kiddie tax,” children owe nothing on the first $850 (in 2006) of investment income earned. The second $850 is taxed at the child’s rate, which is usually a low 5% on dividends and long-term capital gains, and no more than 10% to 15% on short-term gains and interest. Investment income exceeding $1,700 is taxed at the parents’ tax rates: 15% for dividends and long-term gains, and up to 35% on interest and short-term gains.
With the potential for good intentions becoming a costly burden, your clients should be reminded that there are other ways to gift that will not put such a heavy tax burden on recipients. You may want to discuss these gift giving options that could save them from added expenses.
Gifting for Retirement and School
Annual exclusion gifting can be a good way to encourage the next generation to save for retirement. For example, for grandchildren with part-time jobs, a client’s gift may help them fund a Roth individual retirement account (IRA). Remember, to be able to contribute to a Roth IRA, the donor must have earned income that does not exceed $160,000 (for married couples filing jointly) or $110,000 (for singles and heads of household).
A classic use of annual exclusion gifting is the 529 Qualified State Tuition Plan (529 plan). Keep in mind though, that if your clients have uniform gift to minors accounts (UGMAs), they may want to transfer them to a 529 plan to take advantage of the tax-deferred growth.
A few cautions are warranted, however. For example, when the child reaches the age of trust termination (meaning the age of maturity, which varies by state), the child will become the account owner of the 529 plan, so beneficiaries cannot be changed at a parent’s whim. The assets will be included as the child’s for financial aid purposes. Another caution is that 529 plans only accept cash (and not what was already in the UGMA), so the account must liquidate, which may result in a tax liability.
Your client may want to open another 529 plan for additional contributions that follow the normal 529 rules. A separate 529 plan will allow your client to have “control” as owner of these assets and therefore can ensure they will be used for college expenses.
Many people ask if it is possible to take UGMAs back. The answer, unfortunately, is no. Once the money has been given to the child, it is owned by that child. However, nothing prevents the custodian from spending the money for the benefit of the child, so long as the expenses are not “parental obligations” or would otherwise benefit the custodian. Parental obligations are expenses a parent is normally expected to provide his or her child, such as food, clothing, medical care, and shelter. But if your client’s child wants a computer or would like to go to summer camp, it is usually acceptable to spend the child’s money on those expenses.
Of course, the 529 plans are not the only way an individual can gift for education. Your clients could consider paying expenses directly to the educational institution, helping a friend or family member without it being considered a gift. To qualify for the unlimited exclusion for qualified education expenses, a donor must make a direct payment to the educational institution for tuition only. Books, supplies, and living expenses do not qualify. If your clients want to pay for books, supplies, and living expenses in addition to the unlimited education exclusion, they can make a gift of $12,000 to the student under the annual gift exclusion. Remind your clients that they can take advantage of this rule by paying for music, dance, or pre-kindergarten tuitions, too, for example.
Gifting for Health
The same rules apply to medical expenses. Medical payments must be paid directly to the person providing the care to qualify for the unlimited exclusion. Qualifying medical expenses include:
- Diagnosis and treatment of disease
- Procedures affecting a structure or function of the body
- Transportation primarily for medical care
- Medical insurance, including long-term care insurance
We often get so caught up in our clients financial matters that we forget one of the most important gifts parents can give their children: Comfort. Ask your clients if they have a living will, health care proxy and advance directive, such as a “DNR” (do not resuscitate) that formally states their intentions. Without legal documentation, your clients are relying on family and friends at a potentially critical time to know what they would have wanted. (See the “Health Gifts to Consider” sidebar above.)
As you close out 2006 and prepare your clients for another financially fit year, take the opportunity to discuss gifting with them and help ensure that their objectives for their estates are in line with their overall financial and life goals.