Individuals with significant assets should take advantage of proven tax strategies such as gifting and direct payments to educational institutions to transfer wealth to heirs tax-free, as well as minimize estate taxes. Additional opportunities are available as well, thanks to low-interest rates and a volatile stock market. Let’s take a look at some of them:
The annual gift tax exclusion provides a simple, effective way of cutting estate taxes and shifting income to heirs. For example, in 2022, you can make annual gifts of up to $16,000 ($32,000 for a married couple) to as many donees as you desire. The $16,000 is excluded from the federal gift tax so that you will not incur gift tax liability. Furthermore, each $16,000 you give away during your lifetime reduces your estate for federal estate tax purposes. However, any amounts above this limit will reduce an individual’s federal lifetime exemption and require filing a gift tax return.
Direct payments for medical or educational purposes indirectly shift income to heirs; however, it only works if the payments are made directly to the qualifying educational institution or medical provider. This strategy allows you to give more than the annual gifting limit of $16,000 per donee. For example, if you’re a grandparent, you can pay tuition directly to your grandchild’s boarding school, college, or university. Room and board, books, supplies, or other nontuition expenses are not covered. Similarly, they can make direct payments to a hospital or medical provider. Medical expenses reimbursed by insurance are not covered, however.
Loans to Family Members
This strategy works by loaning cash to family members at low interest rates, which is then invested with the goal of reaping significant profits down the road. With mid and long-term applicable federal rates (AFR) rates for October 2022, as low as 3.28 and 3.43 percent, respectively, heirs can lock in these rates for many years – three to nine years (mid-term) and nine to more than 20 years (long-term).
Grantor Retained Annuity Trust (GRAT)
Another relatively low-risk strategy is the grantor retained annuity trust (GRAT), where the donor transfers assets to an irrevocable trust and receives an annuity payment back from the trust each year. This strategy enables heirs to profit from their investments long-term if returns are higher than the IRS interest rate. Now that IRS interest rates are so low, this is easier than ever to do. In October 2022, the interest rate used to value certain charitable interests in trusts such as the GRAT is 4.00 percent.
Roth IRA Conversions
Contributions to a traditional IRA are made pre-tax, which means distributions are considered taxable income; however, the tax is paid upfront with a Roth IRA, and distributions are completely exempt from income tax. This feature makes converting a traditional IRA to Roth IRA and rolling it over to an heir an attractive option, especially during a financial crisis. The conversion is treated as a rollover where the trustee of the traditional IRA is directed to transfer an amount from the traditional IRA to the trustee of the Roth IRA. The account owner pays income tax on the amount rolled over in the year the account is converted, which allows the account to accumulate assets tax-free and future distributions are tax-free.
Russo CPA is a trusted advisor on tax strategies related to wealth management; please call our office and speak to Robert Russo directly (Ext.1) for assistance.