Generational Generosity

     Would you rather transfer your wealth to the IRS or to your loved ones? If you answered the IRS, then disregard this article. On the other hand, if you answered your loved ones, then read on. We will review some of the relevant tax rules for lifetime gifting, then examine two common transfer methods (along with a few of their potential pitfalls).

Gifting Fundamentals

     Every taxpayer may transfer up to $12,000 each year to an unlimited number of individuals. This is known as the Annual Gift Exclusion (AGE). Through gift splitting, spouses may give a total of $24,000 each year to an unlimited number of individuals (even if only one spouse is the sole source of the funds gifted). Such lifetime gifts made within these dollar limitations do not trigger gift taxes when made, nor do they reduce the combined Applicable Exemption Amount available to protect lifetime transfers of wealth exceeding AGE limits and postmortem transfers of wealth.
     Accordingly, maximizing transfers within the limits of the AGE has been and remains a prudent method to transfer wealth between generations. [Exception: Qualified payments in any amount made directly to an educational institution for tuition and directly to a provider of medical care on behalf of any individual are fully excluded from gift tax consideration and may be made without dollar limitation.]

EGTRRA Exemption

     Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), taxpayers are able to make total lifetime tax-exempt transfers of wealth totaling $1 million independent of the AGE limitations. For example, a widow with five grandchildren could transfer a total of $1.06 million to them free of gift taxes all in the same calendar year. Additionally, this $1.06 million would be excluded from her estate for determining any future estate tax liability, as would any future appreciation on the gift. [Note: On the downside, however, the grandchildren would receive their grandmother’s cost basis in the gift, triggering potential capital gains taxation on any appreciation above cost basis. Proper estate planning often requires balancing your tax and non-tax objectives.]
     Depending on the size of your overall estate and your ability to make gifts without affecting your lifestyle, maximizing your lifetime wealth transfers may be a tax-savvy strategy given the uncertain future of the estate tax. Nevertheless, once you have made the decision to be inter-generationally generous, the next decision is how to make the transfer. Two popular methods are outright gifts and custodial accounts.

Outright Gifts

     An outright gift with no strings attached is the simplest method of making a lifetime wealth transfer. You simply deliver the asset directly to the donee. Once in the hands of the donee, however, your gift may be taken away from them through a divorce, lawsuit or bankruptcy. More commonly, your gift may be squandered, because you have no further control over an outright gift once delivery is made. Fact: No one appreciates the value of a dollar like the person who earned it (and paid taxes on it). Fortunately, the law provides at least one simple alternative to protect gifts, particularly when made for the benefit of minors.

Custodial Accounts

     Custodial accounts established under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) are very popular methods of making transfers to loved ones who are minors. They are popular because they are convenient and inexpensive to create. Almost all financial institutions offer such arrangements.
     Beware: The account becomes the unrestricted asset of the beneficiary upon reaching age 18 or 21, depending on applicable state law. In other words, it could be used for fast cars and stereos, instead of books and tuition.

Summary

     Inter-generational generosity makes good sense for a variety of reasons. However, great care must be given to the method of transfer to avoid the potential pitfalls of these do-it-yourself methods.