Time to Read: 8 Minutes

One of the most fulfilling roles as an advisor at BWM Financial is helping our clients use their money as a tool to do the things in life they enjoy most. For many of our clients, that means developing creative, tax-efficient strategies for making life changing gifts to their loved ones. In Part 5 of a 7-part series, “Tax Saving Strategies for High Earners,” we break down the strategy and tax benefits involved with gifting stock to your family, frontloading gifts through intrafamily loans, kickstarting your child’s retirement savings, and supersizing college savings.

#1: Giving the Gift of Appreciated Stock

Parents often gift money to their kids and grandkids by simply writing them a check. But gifting appreciated investments may be better, especially if you hold a significant amount of stock in the same company that writes your paychecks. First, you’re reducing unrealized capital gains. Second, if your kids or grandkids have low income, they may be able to sell their gifted stock without paying any capital gains tax. Essentially, you and your kids may end up paying zero capital gains on a stock that’s been appreciating for years.

Specifically, if the recipient is a single taxpayer with taxable income of $40,000 or less, he or she might pay 0% in federal capital gains tax. Married taxpayers filing jointly with taxable income of $80,000 or less might also benefit from the 0% capital gains tax rate*. So, although you’re passing unrealized gains when gifting appreciated stock, the lower tax bracket may mean they can realize those gains for little or no tax consequences.

Oftentimes clients ask BWM advisors if they should gift their company stock with large unrealized gains. These gains are typically acquired through equity compensation vehicles like Employee Stock Purchase Plans (ESPPs), incentive stock options, and restricted stock options (RSUs). It’s important to keep in mind that these grants can have their own tax rules. For example, if you gift stock from your ESPP, the discount you received at the time you purchased the stock may be added to your taxable income in the year your gift is made. These rules underscore the importance of working with financial and tax advisors who have experience with equity compensation so be sure to leverage their expertise.

If you have underperforming stock, it can also make sense to sell at loss and gift the cash proceeds to your kids. For example, if you have a large tax liability from recognizing significant gains in the current year, selling stock for a loss may help you offset some of those gains and reduce your tax liability.

Getting Investing Started Early

A custodial brokerage account is a taxable account established and controlled by a parent or other adult for the benefit of a minor. If you’d like to retain control of the investments after your kids turn 18 (or 21 in some states), you may want to set up a trust that puts some restrictions on when your kids or grandkids can access the money. BWM suggests consulting with your attorney about the appropriate steps to take when setting up accounts for your children.

Once you’ve opened account, you can simply transfer stock directly. It’s an in-kind transfer, not a sale, so the stock doesn’t trigger tax consequences. Essentially, the unrealized gain is transferred along with the gift. If the position you’ve gifted is a part of your investment strategy that you’d like to keep, you can purchase the same stock in your own portfolio, and you’ll have reduced your unrealized gains.

Before gifting to your kids, you may consider leveraging both your annual gift tax exclusion ($15,000 to any one person free of gift taxes in 2021) or review opportunities for larger gifts by leveraging your lifetime exemption amount. Checkout our Gifting 101 article to learn more about gifting rules, benefits, and methods to be considered. You should also contact your CPA regarding potential gift, estate, and kiddie tax implications.

#2 Help kids buy their first home through intrafamily loans with yearly debt forgiveness

Given the recent appreciation of the housing market, particularly in San Diego and Southern California, BWM advisors are frequently asked how parents can help their young adult children or grandchildren buy their first home. While many parents may think to make a large upfront cash gift, lending your kids money may be more tax efficient.

This involves making an intrafamily loan from the “Bank of Mom and Dad.” For this strategy, you effectively act as the lender to your kids. Each year, you can “write off” or “forgive” your kid’s debt up to your $15,000 annual exclusion amount per person ($30,000 if married filing jointly). So long as you don’t forgive more than your annual exclusion, the IRS will consider this a tax-free gift. This is a way to give your kids a large upfront gift in a single year without triggering gift taxes or affecting your lifetime exemption amount. Here’s an example to explain…

Your daughter, Jill, and her husband, Bill, need $400,000 to buy a home. For an intrafamily loan, the IRS will say Jill and Bill must pay you a minimum interest rate. For simplicity, let’s say that rate is 3%, which comes out to $12,000 per year [$400,000 x 3%]. Since you and your spouse may gift them up to $60,000 per year [$30,000 annual exclusion x 2 persons] without tax implications, you can simply choose to forgive the $12,000 of annual interest and $48,000 of principal on December 31st. In this scenario, the $60,000 of debt and interest forgiveness per year counts as a tax-free gift that won’t eat into your lifetime exemption amount. Make sure your loan forgiveness is clearly documented in writing.

If your financial plan can’t afford to gift up to $60,000 per year, another option would be to lend Jill and Bill $400,000 through an interest-only loan. Again, let’s assume an interest rate of 3%. In this case, you can forgive the $12,000 of interest each year and agree on some type of principal repayment plan.

If you are considering making an intrafamily loan, BWM recommends reviewing your financial plan with your advisor to see how much you can afford to give. You can also work with BWM Director of Wealth Planning and former tax attorney, Chris Pegg, who will help lay the foundation of how the arrangement might work, positioning you to then consult with your estate planner to make sure the proper legal documents are drafted and signed.

#3 Jumpstart Retirement Savings

Getting a full-time paycheck and access to a 401(k) plan and other employer benefits is an adult milestone. But for the first few years, it’s difficult to set aside enough to even get the corporate matching funds. While learning to live on your own is important, building for retirement in the current environment is a necessity and the earlier you start, the better the outcome. There is a compromise solution.

Employer 401k

While you can’t make direct contributions into a child’s 401(k), you can gift him money with the intention of him saving more for retirement. That is, the money he would have otherwise spent on his living expenses can be contributed into his 401(k). For example, if you gift your son $15,000 per year to help cover his rent, he in turn could contribute at least $15,000 to his 401(k) or IRA accounts. This allows parents to retain some control over the funds, and to have the satisfaction of knowing they are building for the future. It will also lower kids’ taxable income, as there are no tax consequences to the gift, but 401(k) contributions are made with before-tax dollars.

Health Savings Accounts (HSA)

If your child has access to a Health Savings Account (HSA), you may also consider putting your gift towards his HSA contributions. In 2021, he may contribute as much as $3,600 into his HSA. He would get an immediate tax deduction, the investments in his HSA will grow tax-free, and he can take tax-free distributions in retirement if they’re used to cover his healthcare costs. 

Because the IRS does not require to take HSA distributions in any set timeframe, we suggest your son covers his out-of-pocket healthcare costs before retirement using money in his bank accounts. If he does this, he’ll retire with a dedicated investment account specifically set aside to cover healthcare costs in retirement. To learn more about the tax-benefits of HSAs, checkout our article – Health Savings Accounts: A Simple Tax Break for High Earners.

Custodial IRA

You may open and fund a Custodial IRA for any child, regardless of their age, if they have earned income. You can make a maximum IRA contribution of $6,000 per year* but may not exceed the child’s earned income. These contributions can be made by anyone (a parent, family member, friend, etc.).

Since kids typically don’t earn enough money to benefit from tax-deductible Traditional IRA contributions, funding a Roth IRA often makes the most sense. There’s no immediate tax break associated with Roth contributions, but investments in a Roth IRA grow tax-free and are not subject to required minimum distributions like Traditional IRA funds. To learn more about all the benefits associated with a Roth IRA, you can refer to our article – Roth Conversion: A Better Way to IRA.

Or any other tax-advantaged savings vehicle

While the examples above are the most common strategies we see practiced, your kids might have access to other tax-advantages savings options through their employers or other means. Although their personal cash flow might not allow for saving, you could help supplement their day-to-day expenses through a gift. In turn, they can direct a portion of their paychecks to tax-advantaged retirement accounts. The time-value of money and tax-advantaged nature of these options can quickly compound to differences of hundreds of thousands of dollars by the time they retire.

#4-How can I maximize 529 plan contributions?

As tuition costs at all education levels continue to rise, developing an effective savings strategy to fund your child’s education has become increasingly important. While many individuals may think they can only fund a 529 plan up to their $15,000 annual exclusion amount per year ($30,000 for married taxpayers filing a joint tax return), the IRS actually provides a special tax-free way to frontload five years of contributions into 529 plans in a single tax year.

This means a single taxpayer may gift up to $75,000 [$15,000 annual exclusion x five years] in a single year to any one beneficiary free of gift and estate taxes. For married taxpayers filing jointly, the maximum one-year contribution jumps to $150,000 [$30,000 annual exclusion x 5 years]. On top of that, the IRS says your taxable estate will be reduced by the amount of your 529 contributions. This helps decrease the sum of your assets that may be subject to the 40% estate tax at the end of your lifetime.

Since the IRS treats five-year “super funding” as if you and your spouse gave $30,000 per year for the next five consecutive years, it’s important to understand that you may not make any additional tax-free gifts to your three children for the five years following your frontloaded 529 contributions. These contributions must also be reported on a gift tax return (Form 709) for the next five years. Before filing your taxes, make sure your CPA knows about your supersized 529 contributions.

How can BWM Financial help?

As part of our service to clients, BWM Financial will evaluate the tax-efficiency of your current gifting and estate planning strategy. We can look at your full financial picture and show you the most tax-advantaged ways of transferring wealth to loved ones without impacting your lifestyle or future needs in any way.

Our Director of Wealth Planning, Chris Pegg, and other BWM advisors can work directly with your CPA and estate attorney to help you create more advanced gifting and estate planning strategies as needed.

If you’re looking to make significant, thoughtful gifts to your loved ones in a tax-efficient way, please contact BWM. While we are not tax advisors, we will provide high-level advice that can be evaluated with your CPA and estate attorney and then put into action.

*As always, tax rates and limits are subject to change.

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Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial.  The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.