5 Ways To Pass Down Generational Wealth Tax-Free
If you happen to be in a financial position where you’re planning to pass down generational wealth, congratulations! You’re in a great situation, compared to the bottom ⅔ of Americans who are living paycheck-to-paycheck (according to CNBC). But be sure your hard-earned nest egg is passed down in as tax-efficient manner as possible. That is to say, if you know your estate and gift taxes well, hopefully you can skirt around paying hefty estate taxes. Otherwise, your nest egg can be taxed as high as 40% at the federal level, plus any estate taxes your estate may have to pay at the state level! Luckily, today I will share some of my favorite ways to pass down that generational wealth without paying a single penny in taxes!
Gift, estate, vs inheritance taxes
First, let’s talk about the differences between the 3 types of taxes:
Gift tax. The donor pays taxes when gifting an asset (e.g. money, property) to someone, not the beneficiary (recipient). Federal government has gift taxes; most states do not.
Estate tax. The estate pays taxes upon death, not the beneficiary of the estate. Federal government has estate taxes; most states do not.
Inheritance tax. The beneficiary pays taxes upon receipt of an estate. Federal government does not have inheritance taxes; most states don’t either.
Lastly, gift taxes occur while you’re alive. Both estate and inheritance taxes occur upon death. The difference between the two is that estate taxes are paid by the estate before distributions are made to the beneficiaries, whereas inheritance taxes are paid by the beneficiaries after distributions are received from an estate.
To keep this article focused on reducing taxes on generational wealth, I will only talk about gift and estate taxes; inheritance taxes aren’t common.
1. Annual gift tax exemption
As of 2021, an individual can gift up to $15,000 per recipient per year without paying any gift taxes, to as many recipients as they want. So if you have 2 children you can gift $15,000 to each of them without incurring any taxes. Additionally, your spouse can do the same, coming to a combined $30K in annual gifts per child, tax-free!
What qualifies as a gift? Pretty much any asset of value, like cash, property, stocks, etc. But if you transfer assets that have appreciated in value and you gift them, you can win in several ways:
You reduce how large your estate will be when you pass.
You avoid paying taxes on any appreciation of those assets.
If you give a gift to a child under 18, their income bracket is likely much lower than yours. Under what’s known as the Kiddie Tax, the first $1,100 of unearned income is tax-free, and the second $1,100 is subject to the child’s income tax rates, which could be as low as 10% at the federal level. Anything above that is taxed at the parents’ tax rate.
2. Lifetime gift and estate tax exemption
Any amount over the annual gift tax exemption goes towards your lifetime gift and estate tax exemption. As of 2021, the estate and gift tax exemption is $11.7 million per individual while a married couple is double that at $23.4 million. This amount is indexed for inflation, so it should continue to rise every year. What this exemption means is that any individual can gift up to $11.7 million during their entire lifetime (above their annual $15K gift tax exemption) and avoid paying taxes on the entirety of it.
For example, if you gift $16,000 to an individual in a single year, the first $15K is exempt from gift taxes due to the annual gift tax exemption. But the last $1K is exempt from gift taxes due to the lifetime gift tax exemption, reducing your lifetime exemption down from $11,700,000 to $11,699,000. To completely avoid using any portion of your lifetime gift tax exemption that year, all you would have to do is simply to wait to gift any more until the following year.
3. Medical and educational expenses
Another way to pass down generational wealth is by paying for medical and educational expenses directly to the medical or education provider. And the great thing about this is that there is no limit to how much you can cover for them.
This method is not to be confused with contributing to someone’s 529 plan, for example. Contributing to an individual’s 529 plan counts as a gift, whereas a payment made directly to the college does not. Same goes for medical bills. If you write a check directly to the medical institution, it does not count as a gift. If you were to write the check to the individual receiving medical care so they can pay for a medical bill, then that would be considered a gift. Know the difference!
What’s the point of a 529 then? While paying a college directly does not count as a gift, the money you use to pay the college could’ve been invested in a 529 instead. Investing in a 529 would allow those contributions to grow over the years and be withdrawn tax-free!
4. State gift and estate taxes
As I mentioned previously, most states don’t have gift or estate taxes. But you’d best check to make sure your state isn’t one of the few that does. The Balance has a great chart that will help you find out.
5. Irrevocable trusts
Irrevocable trusts can also be used to transfer generational wealth. By transferring your wealth to an irrevocable trust, you essentially reduce your taxable estate by the amount you transfer. However, the big downside to doing so is that you lose full control over those assets. For most people, it usually doesn’t make sense to use them unless you’re certain you’ll exceed the lifetime gift and estate tax exemption. However, it may still be a great option for those who want to gift now but are concerned about how the beneficiary (or beneficiaries) will manage those assets.
What to gift and how
529s
As opposed to other investment accounts like UTMAs, 529 funds are specifically earmarked for education expenses, so there’s less concern about your child using this money irresponsibly (though not impossible).
Contributions to your child’s 529 plan are considered gifts, but a married couple can gift up to $30K per year using the annual gift tax exemption. Additionally, 529s are unique in that they allow you to “pull forward” up to 5 consecutive years’ worth of annual gift tax exemptions into a single calendar year. That would max out at $75K per person, $150K per married couple! And you can do this every 5 years, if so desired.
Of course, you may not want to earmark “too much” into 529s since they must be used for education expenses. Otherwise, withdrawing earnings on non-qualified expenses will be penalized 10% and taxed. Nevertheless, 529s are still a great way to pass on generational wealth, since your child can simply reassign the 529 to their child in the future. And their child can reassign the 529 to their child, and so on and so forth.
UTMAs
An UTMA is a custodial account setup by a parent (or grandparent) with the child as the beneficiary. The parent is the custodian who manages the account until the child reaches a certain age, usually between 18 and 25 (varies by state).
Once an asset, like cash or stocks, is gifted into the child’s UTMA, you are moving that asset out of your estate and into the child’s, thereby reducing your total taxable estate. And because you are gifting assets to your child, the value of the gift goes towards your annual gift tax exemption of $15K. Anything over $15K gets deducted from your lifetime gift and estate tax exemption.
Note that the child will have to pay taxes on any earnings from the UTMA (see Kiddie Taxes above). Also, once your child reaches the age at which the UTMA officially transfers out of the custodian’s control and into your child’s, they can do whatever they want with it. This is unlike a 529, where the money is earmarked for education and isn’t easy (or attractive) to withdraw.
Custodial Roth IRAs
It goes without saying that Roth IRAs are very powerful, tax-advantaged retirement accounts. So why not get your child started as young as possible? If your child has any earned income in a given year, you can open up a custodial Roth IRA for them!
They can contribute their earned income into their Roth IRA every year, up to the $6,000 annual limit. That is to say, if they earned $3,000, they can only contribute up to $3,000. If they earned $10,000, they can contribute up to the $6,000 annual limit.
But instead of having your child contribute their earned income, you can “match” their earnings by contributing however much they earned (up to $6K) into their Roth IRA. That way, your child gets to keep their earned income and spend (or invest, ideally) it elsewhere. Plus, you get to use some of your annual gift tax exemption every year they earn income, and they get to watch their Roth IRA compound at a very young age and receive tax-free growth!
Highly appreciated assets
Highly appreciated assets are typically better to pass down through your estate rather than as gifts while you’re alive, because when an estate’s assets are distributed to its beneficiaries, the beneficiaries receive a step-up in cost basis. This means that as soon as they receive the asset, if they sold it the very next day, they’d likely owe little to no taxes on it because there’d be minimal appreciation in a single day.
For example, if you purchased $100,000 worth of shares in Company XYZ and those shares are valued at $1M at the time of death, your beneficiaries would receive a step-up in cost basis. This essentially means that your beneficiaries’ acquisition price is $1M, not your $100K price, and they can sell the shares without paying any capital gains!
How these tax laws are at risk
The current $11.7M lifetime gift tax exemption amount is set to expire at the end of 2025 unless it’s renewed by the government. If it’s not renewed, it’ll go back down to $5.49 million per person.
Also, the current administration is proposing even more changes to the tax code:
Reducing the estate exemption down to $3.5 million, lower than the previous $5.49 million exemption level and back to the 2009 level.
Eliminating the step-up in cost basis. See the above section called “Highly appreciated assets” for what this means. Eliminating the step-up in basis could potentially be a massive tax bill for beneficiaries of large estates. With the step-up in basis, there’s potentially a zero tax bill.
Increasing the highest estate tax rate from 40% to 45%. If you plan well and pass down generational assets during your lifetime so that passing down your estate when you pass results in a low-to-no tax bill for your estate or its beneficiaries, you don’t have to worry about estate taxes.
If you happen to have the means to pass on such wealth, you can “lock in” the current lifetime gift and estate tax exemption by gifting before 2025. Or if the current administration passes something sooner, you may have to gift even sooner. One big reason to gift at least some of that now (besides the drastic reduction in the exemption amount) is that your estate has a much higher potential to grow above the current $11.7M exemption. And if, in 2026, the exemption gets dropped to $5.49 million, any amount over that will be subject to massive 40% estate tax rates!
Conclusion
Clearly, passing on generational wealth (and at such extensive levels) is a good problem to have. But to ensure as much of that wealth is preserved, you must understand gift and estate taxes well so that you can plan accordingly.
Hopefully, some of my suggestions have planted some interesting tax-efficient ideas in your mind. Feel free to reach out to me by commenting below or reaching out to me directly if you have any questions!
