Understanding how to manage your gifting strategy so you can minimize your taxes is crucial. Let’s discuss how to build a strategy that works for you.
The Internal Revenue Service (IRS) recently increased the amount individuals can gift tax-free up to $18,000 for 2024. If gifting is an important part of your financial plan, understanding exactly how to structure your gifting strategy to minimize the tax impact is critical.
Understand the gift tax annual exclusion
The federal gift tax‡ is a tax on the transfer of property by one individual to another while receiving nothing, or less than full value, in return. This can include large gifts of money, property, investment accounts or other assets. If a donor exceeds the gift tax limit in a calendar year, they may have to pay taxes on that gift.
The gift tax is one of the taxes that is adjusted each year for inflation, which is why it is important to check in each year. As stated above, the annual limit is $18,000 for 2024. You should also note that married couples can spilt gifts, meaning a couple can combine their individual gifting limits to enhance the benefits of tax-free gifting. In addition to the federal limit, each state can have different limits too, which you’ll want to investigate before finalizing your plan.
Establish your goal
Now that you understand the basics of the gift tax, your next step is to establish a goal specific to your circ*mstances. For some, the goal might be to pass on wealth to a younger generation while others might have a goal of leaving a legacy in their community. In addition, the goal could be multi-pronged and include many different people or organizations that you care about. Whatever the goal, it should be discussed with your financial team and built into your financial plan. This goal can shift over time and should be part of a regular conversation that you have as your needs and desires change.
Common gifting strategies
There isn’t a one-size-fits-all method for gifting, but there are certain strategies that are more common than others, such as educational gifting, donor-advised funds and qualified charitable distributions.
Educational gifting
One popular method of gifting is for educational purposes. For example, opening and funding a 529 plan for a loved one is a form of gifting. Putting money in a 529 plan also locks the money in for qualified educational expenses and if the funds aren’t used for those purposes, you could face taxes and penalty fees. To avoid this, you can give a child money for education, but use a different savings vehicle, such as a Uniform Transfers to Minors Act (UTMA) account or Uniform Gifts to Minors Act (UGMA) account, also known as custodial accounts. In addition, unused funds can be rolled over to a Roth IRA for the beneficiary.
To get started, first you need to establish a timeframe. Do you want to give a gift for the child’s primary school years or support their higher education? Maybe you want a loved one to attend a private high school or a private university that you attended. Whatever the goal is for the child should be incorporated into your gifting strategy.
Next, discuss which savings vehicles are established or can be established to gift funds. Outside of a 529, you could investigate whether a Coverdell Education Savings Account (ESA), taxable investment account, or U.S. Savings Bonds are the appropriate vehicles to achieve your goals. There are many options that all have pros and cons for achieving your educational gifting goals.
Remember, different states have different amounts that you can gift tax-free. Explore the limits with your financial team and see what works best for your strategy.
Finally, you could gift directly to the institution where the individual is attending by way of the gift exclusion for tuition expenses or a pre-paid tuition plan. And remember, for some types of accounts (e.g., ESAs and 529 plans), you have the flexibility to change the beneficiary to support your loved ones’ educational goals.
Donor-advised funds
The IRS‡ defines a donor-advised fund as a separately identified fund or account that is maintained and operated by a section 501(c)(3) “sponsoring” organization. Donor advised funds (DAFs) allow donors to make charitable contributions, potentially receiving an immediate tax deduction with the ability to advise where grants go over a period of time. DAFs also allow for flexibility if you want to gift funds to multiple organizations. Another key benefit to DAFs is that donations can be invested and grow over time as you decide where to donate them. This type of fund can be a great option for someone with charitable intent and a longer runway ahead to gift the money.
Qualified charitable distributions
A Qualified Charitable Distribution can be an excellent way for charitably inclined individuals to support their favorite charities while minimizing their taxable income. The IRS allows IRA owners to direct their required minimum distributions to an eligible charitable organization in order to avoid the tax liability on such a distribution when it is paid to the charity directly.
For some, the money isn’t needed for their living expenses. In order to create an efficient tax strategy, the distributions can be gifted to different charities. As part of this strategy, each year, the IRS allows individuals to donate up to $100,000 in tax-free gifts to charities (up to $200,000 per year for married couples, if both spouses are age 70 ½ or over and both have IRA’s). There are different requirements for each IRA custodian/trustee that will need to be completed in order to do this correctly, so be sure to talk to your financial team to ensure all the proper steps are taken.
Bunching gifts
Finally, it is important to talk to your team about “bunching” as an effective gifting strategy. To make the most of your potential tax deductions in a given year, it can be beneficial to concentrate your charitable donations into one year, allowing your itemized deductions to exceed the standard deduction for that year. This will allow you to take advantage of your charitable gifts from a tax standpoint when you might otherwise not be able to do so. This strategy can work very well when utilizing a donor advised fund that allows you to take advantage of the larger deductions in year one while spreading your actual contributions out to your favorite charities over a period of years. Your financial team can run different scenarios with you to see what will be more tax-efficient for your personal circ*mstances.
There are a number of alternative gifting strategies available that aren’t as common, but still options for you to consider, such as family limited partnerships, irrevocable life insurance trusts, grantor retained trusts and charitable remainder trusts. These can be more complex (and costly) to set-up and maintain, but under the right circ*mstances, they can be even more effective gifting strategies.
Gifting your funds can create a lasting impact while helping to minimize the impact of taxes. However what you decide to gift should be something you discuss regularly with your financial team as your priorities and strategies can change over the course of your life.
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