Gifting: A Powerful Tool for an Effective Estate Planning Strategy

Reprinted with permission from the February 5, 2024, issue of The Legal Intelligencer

By Justin H. Brown and George M. Riter, Jr.

Regardless of one’s level of wealth, gifting is an important tool for an effective estate planning strategy. Individuals have many potential gifting options, both simple and complex, that may be utilized to pass wealth down to lower generations and reduce the size of one’s taxable estate to avoid estate and inheritance tax at death. These gifting strategies, either alone or in conjunction with others, can have significant benefits to a family if they are started early and done consistently.

One of the simplest techniques for making tax-free gifts to children and grandchildren each year is through the use of annual exclusion gifts. In 2024, the Internal Revenue Code permits an individual to gift up to $18,000 per person per year without any gift tax consequences. These “free” gifts are a powerful way for a parent or grandparent to pass wealth down each year to children, their spouses, grandchildren and their spouses. A married couple can even combine their annual exclusions by splitting their gifts and passing down double the wealth to the next generation. While annual exclusion gifting is easy and effective, one should be cautious of making gifts to minors, individuals with substance abuse problems, and individuals with current or potential creditor issues. Donors should also be careful about making gifts if they are concerned about future eligibility for public benefits.

Another simple strategy for making gifts is to pay for another individual’s education and medical expenses. The Internal Revenue Code permits an individual to pay an unlimited amount of another’s education and medical expenses so long as the education expenses are paid directly to the educational institution and the medical expenses are paid directly to the medical provider. For grandparents, paying a grandchild’s primary and secondary education tuition can be a significant benefit to the grandchild and the grandchild’s family by reducing potential education debt, and it can serve as a powerful gifting strategy to reduce the grandparent’s taxable estate.

If a donor desires to fund another’s current or future education expenses without paying directly to the educational institution, the donor may create or contribute to a 529 Plan for the individual. A 529 Plan can be a powerful vehicle to fund an individual’s education because the Internal Revenue Code permits the assets inside of a 529 Plan to grow tax-free and to be withdrawn tax-free so long as the amounts are used for educational purposes. For example, a 529 Plan gifting strategy is especially effective for a grandparent who wants to start a gifting strategy for a grandchild as a baby before knowing where the grandchild will ultimately go to school. The grandparent could start making annual exclusion gifts to a 529 Plan when a grandchild is born, and as the child grows, the funds grow and compound tax-free and are available when the grandchild ultimately needs them for schooling. The grandparent could also elect to pre-fund the 529 Plan with five years of annual exclusion gifts in a single year to accelerate the growth of the assets in the 529 Plan. If the grandchild needs the funds for something other than educational expenses, the funds may still be withdrawn, subject to income tax on the growth and a penalty on any nonqualifying withdrawal. If the grandchild does not use all of the funds in a 529 Plan after completing education, the beneficiary of the 529 Plan may be changed so that another family member may benefit from the 529 Plan.

If a donor wants more flexibility in the future use of the gifted funds, the donor may create a trust for the benefit of an individual. A trust may impose specific restrictions on the use of funds over a period of time, or it can be designed to be flexible and give the trustee broad discretion to make distributions to a beneficiary for any reason or purpose. A trust may be structured to only receive annual exclusion gifts from a donor, a one-time gift in excess of the annual exclusion amount, or frequent contributions in excess of the annual exclusion amount. If the trust receives amounts in excess of the annual exclusion amount, the donor must file a gift tax return to reduce the donor’s gift tax exemption by any amounts gifted in excess of the annual exclusion amount. If a trust is created that could benefit a grandchild, the donor must be careful that the trust is designed so that it is exempt from the generation skipping transfer tax or the donor must plan for the allocation of the donor’s generation skipping transfer tax exemption on the donor’s gift tax return.

Parents and grandparents may further utilize trusts for lower generation and reduce the size of their estates by making the trusts “grantor” trusts for income tax purposes. With a grantor trust, all of the income tax consequences of the trust flow directly to the grantor or creator of the trust. The grantor therefore pays all of the income tax generated by the trust on the donor’s personal income tax return rather than having the trust pay any income tax. By having the donor pay all of the tax liabilities of the trust, the trust is not depleted by any annual income tax payments which has the same impact as if the grantor had made additional gifts to trust without any gift tax consequences. As an added benefit, by paying the income taxes of the trust each year out of the grantor’s personal assets, the grantor’s taxable estate is being further reduced with each tax payment.

An individual with a traditional IRA may also reduce the size of his or her taxable estate through a Roth conversion. Funds contributed to a traditional IRA and the growth inside of a traditional IRA are not subject to income tax. However, once funds are distributed from a traditional IRA, all of the distributions are subject to income tax. While the funds contributed to Roth IRAs are subject to income tax, the growth inside of the Roth IRA and distributions from the Roth IRA are not subject to income tax. A Roth IRA can therefore be a very powerful tool for tax-free growth and tax-free distributions. An IRA account holder may convert a traditional IRA to a Roth IRA so that all future growth and distribution are no longer subject to income tax. The conversion however, subjects the entire IRA balance to income tax. While many individuals are hesitant to accelerate the income tax consequences, a Roth conversion provides multiple benefits. First, if the income tax is paid out of non-IRA assets, the payment of the tax serves to reduce the size of the holder’s taxable estate at death. Second, the payment of tax by the owner is effectively a gift by the owner to his or her heirs. By paying the tax now, the owner is pre-paying the tax on a traditional IRA so that his or her heirs do not need to pay the tax later. Third, because Roth IRAs are not subject to the minimum required distribution rules, the owner of the new Roth IRA is not required to ever withdraw any assets from the Roth IRA. This enables the Roth IRA to continue to grow and compound tax free for future heirs. Fourth, at the death of the owner, the beneficiaries will enjoy a period of tax-free growth inside of the Roth IRA and will not pay any income tax when the funds are ultimately distributed out of the Roth IRA. If the Roth IRA was payable to a trust exempt from estate tax and generation skipping transfer tax for the beneficiary, this tax free growth can be especially powerful.

Gifting can be an incredibly powerful tool in an estate plan. Whether annual exclusion gifting is used alone or in conjunction with other techniques, an effective gifting strategy passes assets to the next generation and reduced the size of one’s taxable estate. Starting a gifting strategy early and engaging in it consistently can have significant benefit to a family and a donor’s future generations.

Justin H. Brown, a partner at Ballard Spahr, develops creative strategies for wealth transfer, asset protection, and business succession. He also counsels fiduciaries on their duties and obligations in connection with the administration of estates and trusts.

George M. Riter, Jr. is an associate in the private client services group at the firm. He focuses his practice on estate planning for high-net-worth individuals, along with estate and trust administration.

Reprinted with permission from the February 5, 2024, issue of The Legal Intelligencer. © 2024 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.