Although the federal estate tax exemption amount has increased to $5.49 million this year, that doesn’t mean clients can forget about gift and estate tax management. With 20 states imposing their own estate or inheritance tax, having a plan for strategically gifting assets can help clients continue to maximize the amount of money they pass to their beneficiaries and minimize the amount of taxes they have to pay.
But what’s the best way to transfer assets to the next generation? The following strategies range from the simple to the more complex.
Take Advantage of the Annual Gift Tax Exclusion
The annual gift tax exclusion allows clients to gift $14,000 per year (in 2017) to as many beneficiaries as they choose, without affecting their federal estate tax exclusion amount. For example:
- If your client has three children, he could make a gift to each of them, for a total of $42,000.
- A married couple can double that amount.
- Clients who are also grandparents can also make gifts to their grandchildren.
As you can see, these gifts can add up, with no tax consequences. But be aware: If a client gifts more than the annual exclusion amount to a single beneficiary, the excess will be subtracted from the donor’s applicable estate tax exclusion amount, reducing the threshold at which he or she will owe estate taxes. (If gift tax becomes due, it is generally owed by the donor.)
The $14,000 annual gift tax exclusion can be used outright or as part of more complex strategies designed to minimize the gift value and maximize the use of the estate tax exemption.
A Traditional Strategy: The ILIT
With the irrevocable life insurance trust (ILIT), your client can use the annual gift tax exclusion to purchase a life insurance policy, whose value will be excluded from his or her taxable estate. This traditional strategy remains a solid technique for using annual exclusion gifts and providing wealth replacement for the client’s family. The trust, as the recipient of the tax-free insurance proceeds, can direct how the funds will be used for the family’s benefit.
Let’s take Deborah, a high-net-worth client facing estate tax issues. She funds the trust with a $7 million universal life insurance policy.
- The trustee of the ILIT is the policyowner.
- The insured is Deborah.
- The trust, benefiting her four children, is the policy beneficiary.
Deborah can gift $56,000 per year ($14,000 for each of the four trust beneficiaries). The children will each receive a Crummey notice, giving them the option to take a distribution of the $14,000 gift. They will elect not to take the gift, making the funds available for the trustee to pay the insurance premium.
When Deborah passes away, the $7 million death benefit will go to her beneficiaries, outside of her taxable estate. The proceeds from the insurance policy can be held in the trust and distributed per Deborah’s wishes. ILIT assets cannot be used to pay estate settlement costs or estate tax liabilities. The ILIT can, however, contain a provision that will allow it to lend money to Deborah’s estate, or it can purchase assets from her estate to provide liquidity to the estate.
With this strategy, Deborah can gift $7 million tax-free to her children and still reserve her lifetime estate tax exclusion. She is also able to remove $56,000 per year from her estate, tax-free, by using her annual gift exclusion to fund the insurance premiums.
A More Complex Strategy: Split-Interest Gifting
Another route is to help your client create a discounted gift through split-interest gifting.
Grantor-retained annuity trust (GRAT). A GRAT—an irrevocable trust with a split interest—is a popular planning technique that can offer a significant reduction in the gift tax value of transferred assets.