There is a lot of confusion out there, even among many of our most astute clients, concerning estate tax rates, estate tax exemptions, annual gift exemptions and lifetime exemptions. So to begin, here are the exemptions for 2016, and where applicable for 2017.
Annual gift exemptions
Annual gift exemption remains at $14,000. This means that you may give to any number of different people up to $14,000 per year without any need to report the gift, unless you make other gifts which cause you to exceed this limit. So let’s say you are married, have 2 children and 3 grandchildren. You may give, without gift tax consequences, $14,000 to your two children, $14,000 to each child’s spouse, and $14,000 to each of the grandchildren, which totals $108,000, being 7 beneficiaries at $14,000 each. And if you are married, your spouse may do the same, or you can make the gift on behalf of your spouse without your spouse actually signing a check if the money comes from a joint account.
Create a trust for a family member
If the gift is made directly to the grandchild (assuming the children are adults), and if the grandchild is under age 18, then the money should normally be held for the grandchild’s benefit in a custodial account, with the parent as custodian. If you are making the gifts to grandchildren to reduce your taxable estate, then you, the donor of the gift, should not be the custodian on the account. Normally your child could serve as custodian for the grandchild’s account. The downside to this approach is that the grandchild is legally entitled to take control of the funds in such a custodial account upon attaining the age 18. If you have been contributing to an account for the grandchild for a number of years, there could be more in this account than you wish for the grandchild to take control of at such a young age. To avoid this problem, many people create a trust for the grandchild (or of course for your child where your child is still young), and you may even maintain control of the trust for the grandchild if your trusted estate planning attorney uses the magic words when drafting the trust (and I don’t mean “please” and “thank you”, although those still are magic words, just a bit out of favor perhaps these days). The trust could allow you and/or your spouse to control the grandchild’s trust assets for as long as you wish, or you could step down as trustee and leave your child, the grandchild’s parent, as trustee to control the grandchild’s trust.
Tax benefits of the trust
There are a number of tax benefits which come from this structure, both estate and income. As for estate taxes, these annual gifts help to reduce the size of your estate, thereby reducing the potential 40% estate tax which may be due upon your death. Also, the growth and income on the trust assets accrues within the grandchild’s trust for his or her benefit, thereby avoiding estate tax as well at your death. Also, the income in the trust is normally taxed to the trust itself. If you are in the top income tax bracket, it is likely the trust will be, at least for a number of years, in a lower income tax bracket, thereby reducing overall income taxes. If you want to take full advantage of reduced income tax rates, the income may be distributed to the child, into a custodial account, and that income will be tax-free up to $1050 of income, and taxed at only 10% on the next $1050 of income. If distributions are made to the grandchild while the grandchild is under age 23, then the remainder of the income taxable to the child is taxed at the child’s parent’s income tax rate. So timing of distributions is possible to make maximum use of these tax differences.
One small complication with making gifts to trusts is that each such gift must be made subject to withdrawal by the child or by the child’s guardian. This withdrawal rights is handled by sending to the child or his guardian an annual notice of right to withdraw, commonly known as the Crummey withdrawal right. In thirty years of dealing with Crummey withdrawal rights, I have never had a beneficiary actually get any funds this way. One reason is, they know that if they take the funds, the gravy train will stop. There can be other reasons. In any event, in order to be sure such a gift will not be subject to the gift tax, these annual notices should be sent, and a record of the sending should be kept.
In my next installment, I will write a bit more about annual gifting, and how annual gifts and the lifetime gift exemption of $5.49 million are coordinated and how you can make maximum use of both. Stay tuned!
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