Building Generational Wealth: Strategic Approaches to Financial Gifting

Building Generational Wealth: Strategic Approaches to Financial Gifting

April 15, 2024

Summary

  • There are many reasons why people choose to gift money to other individuals, for example:
    • A parent may want to assist their child with a downpayment on a home.
    • A grandparent may want to contribute funds to a grandchild’s education.
    • An individual may want to reduce their state or federal estate taxes2.
    • An individual may want to help a loved one get a jumpstart on investing.
  • There are several ways to gift funds:
    • Direct and Indirect Transfers
    • UMGA/UTMAs (Custodial accounts)
    • Trust Accounts/Non-retirement accounts
    • 529 plans
    • Less common Coverdell and ABLE accounts

 

Direct and Indirect Transfers

A direct transfer takes place when somebody directly transfers cash or assets to another individual, for example, Patty could gift Richard $10,000. An indirect transfer takes place when somebody makes a transfer of cash or assets on behalf of a beneficiary but not directly to them. For example, Patty could pay off Richard’s credit card balance.

An individual can directly or indirectly transfer any kind of security or cash at any time without limitation, but gifts are subject to the federal gift tax1. The gift tax stipulates that any gift amount over $18,000 will be subject to tax, typically paid by the person gifting the cash or assets. The $18,000 threshold is measured per gifter, per year, per beneficiary. This means that an individual can give a gift to any number of people, and each gift is tax-free up to $18,000. For example, both individuals of a married couple could gift each of their children $18,000 every year, without playing any taxes, for a total of $72,000 collectively.

There are two exceptions to the gift tax allowed by the IRS: payment of educational or medical expenses on behalf of another individual. Individuals can pay educational expenses on behalf of a loved one by paying the educational institution directly. For this option, there is no limit on the amount you can contribute and this means of gifting is not subject to any gift tax. Individuals can contribute in this way toward medical expenses as well.

 

UGMA/UTMAs (Custodial Accounts)

Because minors can’t enter contractual agreements, they are unable to own securities outright. So, custodial accounts serve as a workaround for parents to transfer these assets to their minor children - without setting up a trust. There are two types of custodial accounts: UGMAs and UTMAs. In either a UGMA or a UTMA, the adult who setup the account acts as custodian and manages the account until the account is transferred into the minor’s name when they reach the age of majority dictated by the state in which the account is held. For example, the age of majority is age 21-25 in Washington state.

Any kind of security or cash can be transferred via a custodial account without limit, but gifts over $18,000 per year per child are subject to the gift tax. Additionally, any income generated by the account is taxed at the income level of the minor named in the account, and the transfer is subject to the kiddie tax. The kiddie tax is a tax on children’s unearned income, such as investment income from a trust or UGMA/UTMA. In 2024 for 2023 income, the first $1,250 of unearned income is not taxed. The next $1,250 is taxed at the child’s tax rate, and any amount over $2,500 is taxed at the parent’s tax rate.

 

Trusts and Non-Retirement Accounts

There are many different types of trust accounts for various purposes, but in general a trust account is a legal contract which stipulates how funds or assets are distributed to a beneficiary. A trust is setup by a grantor, the person gifting or transferring money. A trust is executed by a trustee, the person responsible for managing the distribution of funds to the beneficiary.

Trusts are more expensive than other types of financial gifting. In part, this is because they are highly customizable unlike other types of transfers, for example, trust accounts can be customized for funds to be distributed according to specific stipulations. This is the primary benefit of a trust compared to a UGMA/UTMA; the gifter can control at what age or under what circumstances the beneficiary will have control over the funds. Funds transferred via trusts are also subject to the kiddie tax and come with higher income taxes than custodial accounts.

Non-retirement investment accounts can also be a vehicle for gifting. For example, Patty could setup a non-retirement account in her own name and contribute to it over time. When she is ready, she could then gift the funds in the account to a beneficiary via direct transfer or as part of a trust. The gift would of course be subject to the gift tax if over $18,000.

 

529 Accounts

A 529 account is a state-sponsored savings account specifically created for the purpose of funding education. Any adult can open a 529 account for anybody – even themselves. There are limits to how much an individual can contribute to a 529 account and these limits vary by state – and regardless of state, contributions over $18 thousand are subject to the gift tax. Contributions grow on a tax deferred basis, meaning earnings aren’t subject to taxes until they are distributed. Plus, withdrawals from a 529 account are tax-free so long as they’re used for qualified education purposes.

Some states offer benefits to opening an account in the state in which you reside, but importantly, the state in which you open the account does NOT obligate the beneficiary to attend school in that state.

Another bonus of 529 accounts is that any unused balance can be transferred to another related beneficiary. For example, a parent could setup a dynasty 529 for their child, and rollover any unused funds to their child’s children.

 

Less Common Gifting Accounts

There are also Coverdell accounts, which were historically useful before 529s offered benefits for K-12 education expenses. While these plans are no longer very common, if you are the recipient of one and have questions please reach out to us.

There are also ABLE accounts, which are tax deferred accounts for individuals with disabilities. These accounts have an annual contribution limit equal to the annual gift tax threshold, which is currently $18 thousand. Again, if you have questions about this type of account please reach out to us.

 

  1. IRS Frequently Asked Questions on Gift Taxes
  2. Washington Estate Tax: What it is and how to Plan for it

 

Important Disclosures:

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.

Prior to investing in a 529 Plan, investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.