During the holidays, many people’s thoughts turn to gifts. Folks find they are either spending countless hours online or at the mall, or an equal amount of time creating a wish-list and hoping Santa delivers. Regardless, gifting-related activities often dominate our Decembers.
From a financial planning perspective, gifting is also a popular topic come year-end. Obviously, gifts are warranted when wealthy parents and grandparents want to shift assets to children, grandchildren or charities. Additionally, giving assets may also be a means of shifting taxable income from a high tax bracket to a lower tax bracket. The American Taxpayer Relief Act of 2012 (ATRA) and its accompanying higher tax rates have made the income-shifting discussion more relevant than ever.
Lifetime Gift Exemption vs. Annual Gift Tax Exclusion Amount
Before we look at specific income-shifting tactics, let’s first review the tax-free lifetime and annual gifting amounts available to taxpayers. Individuals are allowed to transfer up to $5,430,000 (for 2015, indexed annually for inflation) cumulatively during their lifetime and at death free of transfer taxes to non-spouse/non-charity heirs. (Unlimited amounts may be transferred to spouses or charities without the reporting of a transfer.) This is often referred to simply as “the exemption amount.” With planning, a married couple can transfer a total of $10,860,000 between them without incurring transfer taxes.
The annual gift tax exclusion amount is totally separate from the aforementioned exemption amount. Individuals are allowed to gift $14,000 in 2015 to whomever they choose, without using any of their exemption amount. This amount remains unchanged from 2014, up from $13,000 in 2013. This amount is also indexed for inflation. In a year where gifts to an individual exceed the annual exclusion amount, the person making the transfer must file a gift tax return, recording the partial use of his or her exemption amount.
There is another way to benefit one’s loved ones without having to file a gift tax return and without using up annual exclusion dollars; as long as you pay the provider directly, you can pay for medical or tuition expenses on someone’s behalf.
Lastly, charitable gifting is encouraged by the IRS through the use of the charitable deduction. A taxpayer does not pay taxes on securities given directly to a qualified charity, and receives a tax deduction for the gift (subject to certain income requirements).
Tactics for Shifting Income and Assets
Now that you’re familiar with the lifetime and annual gifting limits, let’s take a look at a few specific income-shifting tactics potentially available to you.
Utilize the annual gift tax exclusion amount: Gift $14,000 in cash or appreciated securities to your children or grandchildren each year. Note that if you are married, with planning, you may combine your spouse’s annual gift tax exclusion amount with your own and gift up to $28,000 per child (or other recipient) each year.
Gift appreciated stock to children or grandchildren in lower tax brackets: This tactic was so prevalent that Congress enacted the Kiddie Tax law to limit its effectiveness (see our Kiddie Tax Class 101 article). The law basically taxes unearned income over a certain minimal threshold ($2,100 in 2015) at the parents’ higher marginal tax rate, not the child’s lower rate. Even so, income shifting via appreciated securities may make sense in some cases, for example:
Transfer low-basis stock that you plan to sell to your children. After the stock is sold, they will still pay your tax rate on gains above $2,100, but the first $2,100 could be taxed at a lower rate than you could have experienced had you sold the stock yourself.
Transfer low-basis stock to your children that you do not intend for them to immediately sell. The idea is for the child to hold the securities until he is out on his own and no longer a dependent. At that point, these securities can be liquidated and taxed at the now independent young adult’s capital gains rate, which may be lower than your rate. In the meantime, up to $2,100 of the annual dividends from the stock would be subject to lower rates than you would pay.
Open and fund a 529 Plan: Many parents and grandparents open a 529 college savings plan for their loved ones. Donors can take advantage of special legislation that allows them to lump sum fund five years’ worth of annual exclusions. For instance, a single taxpayer can contribute $70,000 at one time. Married couples can contribute up to $140,000 in one swoop. Note that you must donate cash to these plans, not appreciated securities. However, growth in the account grows free of federal income tax as long as proceeds are used for qualified expenses. Moreover, contributions are considered out of the donor’s estate for estate tax purposes, yet the account owner maintains a certain degree of control over the account. For more detail on this tactic, please read our 529 Plan article.
Give appreciated stock to charity: Charitable giving is often a focus of the holiday season. Donors scramble at year end to make last minute charitable contributions. While there are certainly many qualitative benefits to charitable gifting, especially around the holidays, the charitable deduction is a powerful quantitative benefit as well. This gift can be magnified when appreciated securities are given directly to a qualified charity (or to another form of charity, a Donor Advised Fund).
Let’s illustrate this tactic’s impact by looking at two different ways of gifting $100,000 to charity. We’ll assume that you’ve owned a particular stock for years. This stock has a market value of $100,000, and a cost basis of just $25,000. Assume you are in the highest marginal income tax bracket of 39.6%.
Example 1: You sell the stock to give cash to the charity. If you are in the highest tax bracket, you will pay 20% capital gains tax plus an additional 3.8% because of ATRA’s new Net Investment Income Tax.
You will owe $17,850 in federal taxes ($100,000 – $25,000 cost basis = $75,000 x 23.8% = $17,850)
The charity will receive $82,150 ($100,000 – $17,850 = $82,150)
You will receive a tax deduction of $82,150, subject to certain income requirements.
Example 2: You give the appreciated stock directly to the charity.
You will owe $0 in federal taxes. This is not a taxable event.
The charity will receive $100,000.
You will receive a tax deduction of $100,000, again, subject to certain income requirements.
We hope the benefits of Example 2 are clear: Gifting appreciated securities to charity is not a taxable event. The donor in Example 2 receives a larger tax deduction than in Example 1. The charity receives more money in Example 2 as well.
We have used very basic examples to illustrate this tactic’s advantages. There are ways to make this gifting a part of your regular account rebalancing, but that is a discussion for another time. Some folks may be interested in gifting a more substantial amount to charity. A charitable trust might be a wise option in this case. However, this too, is a topic for another time.
In summary, ATRA has made gifting strategies more important than ever. Despite attempts by Congress to limit some options, there continue to be effective tactics available. We have described just a few. Some are more complex than others. Our hope is that you will call or come by to discuss the most advantageous and appropriate approach for your specific situation. As always, thank you for choosing Bragg Financial Advisors for your financial planning and investment management.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.