As you accumulate wealth, you may aspire to pass that wealth on to the next generation, so that it can continue to grow and benefit your loved ones. However, transferring wealth isn’t always straightforward. Without proper planning, you may lose a significant portion of your estate to taxes.
Indeed, incorporating tax-efficient wealth transfer strategies in your estate plan becomes more important as your net worth grows and as tax laws evolve. In this article, we’ll explore six key strategies that can help you preserve the value of your estate and maximize your family’s inheritance.
Table of Contents
#1: Annual Gifts of Cash
One effective wealth transfer strategy involves making use of the annual gift tax exclusion. The IRS allows you to gift up to a certain amount to as many people as you wish each year without triggering the gift tax or impacting your lifetime gift tax exemption.
In 2023, individuals can gift up to $17,000 per recipient, while married couples can gift up to $34,000. By making systematic annual gifts to your heirs, you can gradually decrease the size of your taxable estate, thereby reducing your potential future estate tax.
#2: Funding a College Savings Plan for Younger Generations
If you have grandchildren or younger family members, education savings accounts like 529 plans can serve as strategic wealth transfer tools.
These plans allow you to invest your contributions so they can grow tax-free over time. Moreover, any withdrawals the beneficiary makes for qualified education expenses are also tax-free.
While contributions to a 529 plan aren’t tax deductible at the federal level, some states offer state tax deductions. In Connecticut and New York, for example, families can take an income tax deduction up to $5,000 for single filers and $10,000 for joint filers on contributions to Connecticut Higher Education Trust (CHET) accounts and NY529 Direct Plan accounts, respectively.
Unique to 529 plans is the ability to front-load five years’ worth of annual gift tax exclusions in one calendar year without triggering the gift tax or impacting your lifetime exclusion. That means in 2023, you can contribute up to $85,000 per beneficiary and potentially realize an immediate tax deduction while reducing the value of your taxable estate.
#3: Paying for College Tuition or Healthcare Expenses Directly
Another tax-efficient wealth strategy you may want to consider is paying for your loved ones’ college tuition or healthcare expenses directly. The IRS allows you to fund these expenses without triggering the gift tax with one caveat: you must pay the institution directly.
It’s also important to note that the exception for direct payments is above and beyond the annual gift tax exclusion. That means in any given calendar year, you can make cash gifts up to the annual exclusion amount and directly pay for your loved ones’ college tuition or healthcare expenses without incurring additional taxes.
This wealth transfer strategy can be particularly beneficial if you have the financial resources to cover what tend to be considerable costs. By paying for these expenses directly, you can alleviate the financial burden on your loved ones, allow you to make a substantial contribution to their well-being, and reduce the size of your taxable estate without incurring the gift tax.
#4: Gifting Appreciated Securities
Gifting appreciated securities—for example, stocks, bonds, or mutual funds that have grown in value since you acquired them—can be a highly effective wealth transfer strategy. One of the main advantages is that as the donor, you can bypass the capital gains tax that you would otherwise incur if you sold the securities yourself.
Meanwhile, if the recipient of the securities chooses to sell them, they’ll likely face a lower capital gains tax than you would if you sold them yourself. This may be the case for two reasons.
First, since the capital gains tax rate depends on the individual’s income tax bracket, younger recipients with less income may pay a lower capital gains tax rate or avoid capital gains taxes altogether. In addition, when the recipient chooses to sell, their cost basis is equal to the value of the securities when they received them.
For example, suppose you acquired the stock at $10 per share, and it’s worth $100 per share when you gift it. Although your cost basis is $10 per share, the recipient’s cost basis is $100 per share. That means if they sell their shares when the stock price reaches $120, the capital gains tax only applies to the $20 difference rather than the $110 difference.
#5: Roth Conversion
A Roth conversion can be another tax-efficient wealth transfer strategy in some cases. When you execute a Roth conversion—that is, move money from a traditional IRA or 401(k) to a Roth IRA—you pay income tax on the amount you convert in the year you make the conversion.
However, the benefit is that all future growth within the Roth IRA, as well as the withdrawals you or your beneficiaries eventually make, will be tax-free, so long as you meet the 5-year rule. Plus, since Roth IRAs don’t have required minimum distributions (RMDs), your funds can continue to grow tax-free during your lifetime, potentially allowing you to leave a larger inheritance to your beneficiaries.
A Roth conversion can be particularly advantageous if you expect you or your beneficiaries will be in a higher tax bracket in the future. Indeed, paying taxes now at a potentially lower rate instead of paying taxes on future withdrawals when your tax rate may be higher can result in significant tax savings over time.
Keep in mind a Roth conversion is a complex wealth transfer strategy, and the tax implications can vary based on your individual circumstances. Be sure to consult with a fee-only financial planner or tax expert before executing this strategy.
#6: Irrevocable Grantor Trusts
Lastly, an irrevocable grantor trust may be an effective wealth transfer strategy depending on the size of your estate. These trusts have unique benefits and drawbacks, which you should consider carefully before moving forward with this option.
When you transfer assets into an irrevocable grantor trust, they’re technically no longer part of your personal estate (unless you die within three years of the transfer). This allows you to reduce the size of your taxable estate by an amount of your choosing.
Irrevocable grantor trusts are unique in that you, the grantor, pay taxes on any income that the trust’s assets generate. While this may seem like a disadvantage, paying the taxes yourself allows you to make an additional gift to your beneficiaries while further reducing your estate.
In addition, you can continue to control and manage the assets within the trust even though it’s irrevocable. This feature can be particularly beneficial if you want to ensure your beneficiaries use the assets in specific ways when they inherit them.
However, irrevocable grantor trusts also have their drawbacks. For instance, once you transfer assets to the trust, you can’t undo it. Therefore, careful planning is essential to ensure you have sufficient financial resources post-transfer.
Additionally, the laws governing trusts can be complex and vary from state to state. Be sure to consult with an expert to understand all implications before proceeding with this strategy.
Consider These Tax-Efficient Wealth Transfer Strategies to Preserve Your Wealth for Generations to Come
Leveraging tax-efficient wealth transfer strategies can make a significant difference in the amount of wealth you’re able to pass on to the next generation. With proper planning, you can ensure your wealth continues to support your loved ones and the causes important to you long after you’ve left this world.
However, keep in mind these strategies can be complex and difficult to navigate without the help of an experienced professional. In addition, there may be additional strategies that align more closely with your values and financial goals.
A fee-only financial planner like Milestone Asset Management Group can help you transfer your wealth efficiently and cement your legacy for generations to come. Our team of experts works collaboratively to understand your financial situation and goals from multiple perspectives, allowing us to provide personalized advice that aligns with your long-term objectives.
To learn more about how we help our clients achieve their financial goals and see if we may be the right fit for your financial planning needs, please schedule an introductory phone call.