If you’ve ever been in the military, you know how much they love acronyms. Don’t get me started on the strange names they’ve given to equipment. There are almost 100 acronyms for aviation units! (Look it up in Wikipedia!) What’s a “Blooper?” No, it’s not a mistake; it’s a grenade launcher (named after the sound it makes). And you thought you knew what a “DISCO” is. In the military, it’s not a place to dance; it’s a Defense Industrial Security Clearance Office…not nearly as glamorous as the acronym might suggest.
Close on the heels of the military is another group of professionals who love their acronyms…estate and trust attorneys. They have GRATs, SLATs, IDGTs, and ILITs, all different forms of trusts for giving to family. In their professional opinion, a “defective” trust is a good thing! There are CLATs, CLUTs, CRATs, CRUTs, DAFs, and PIFs…just a few of the tools for charitable giving. I could go on.
There’s one strategy, however, where attorneys have no acronym…annual family giving. Why? Because it’s simple. No special trusts are required if you’re comfortable giving to family and friends for their immediate use. And, simple can be powerful when gifts are made over time and funds are invested.
How does annual giving work?
Any U.S. person can give away up to $15,000 per year to as many people as they wish with no tax charged on the gift and no income tax payable by the recipient.
What if you want to give more?
If you wish, you and your spouse can each give $15,000 to the same person, effectively doubling the annual limit, again with no limit as to the number of individuals who receive gifts. If you and your spouse each have two siblings who are married, and they each have two children (for a total of four nieces and nephews) and both of your parents are still alive, that’s 12 family members. If you give $30,000 to each of these family members, you can give away $360,000 per year without a gift tax. Over 30 or 40 years, that amounts to a significant sum. Importantly, the limit on annual gifts increases with inflation, so every time the gift limit passes the next $1,000 mark, the limit increases by $1,000. That happens every few years.
How much benefit can be derived from making annual gifts over time? And, by extension, how much can you save in estate tax versus waiting to give funds away when you die?
Let’s take a simple example of a married couple who have a $10,000,000 net worth. They decide to make gifts of $15,000 to each of their five nieces and nephews with gifts increasing annually as permitted by law. As you can see in the chart below, the amount of funds given away over a lifetime is significant. And the couple saves on their eventual estate tax because their taxable estate with annual gifts (the dark blue bar) is less than the estate value without annual gifts (the yellow bar). Below the $0 x-axis, you can see that total taxes paid is lower (light green bar) when annual gifts are made versus when they are not made (dark green bar).
Benefits of Making Annual Gifts for Varied Numbers of Years Until Death
Does every gift count as an annual gift subject to the $15,000 annual limit?
In short, NO! Direct payment for medical expenses to the medical service provider and payment of tuition directly to the school do not count as part of the annual giving limit. So, annual giving can include $15,000 plus medical expenses and tuition (for any level of education, K-12 plus college and graduate school) so long as you pay these costs directly to the provider. These types of additional support can far exceed $15,000 per year per person. In many places, annual tuition for private primary through K-12 can exceed $40,000 and annual tuition for private colleges often exceeds $50,000. Private education from pre-K through K-12 can exceed $600,000 per child. Uninsured medical costs can run into the hundreds of thousands of dollars in a single year.
Do annual gifts have to be given directly to the recipient? Is there a way to save these funds “for a rainy day?”
Yes. Rather than giving directly, annual gifts can be given to a trust so funds can be invested and held for future use by the trust’s beneficiaries. Annual gift trusts can be a powerful estate planning strategy. If the trust is structured so that the donor (referred to as the “settlor” or “grantor”) retains certain powers (such as the power to swap property with the trust), the trust is considered “defective” for income tax purposes. That means the settlor pays the income tax for the trust.
Paying the income tax on a trust benefitting others is one of the most powerful ways to amplify gifts to those who benefit from the trust. That’s because the trust’s investment returns compound at their pre-tax rate, while the settlor benefits by reducing their overall estate by the amount of taxes they pay on behalf of the trust. So, assets outside of the settlor’s estate (in the trust) grow more quickly and the settlor reduces their overall estate tax over time.
How can funds in an annual giving trust be accessed by the beneficiaries?
Beneficiaries of the trust may use funds for the purposes defined by the trust agreement. Some donors prefer their trusts to have broad “discretionary” terms where the trustee can use his/her discretion to determine whether to grant a request for benefits. And some donors prefer to prescribe the types of uses that are acceptable, such as for healthcare and education, or for the purchase of a first home, or the formation of a well-conceived business. It’s also common for trusts to consider supplementing a beneficiary’s income if they choose to pursue a less remunerative profession that they find more rewarding, such as being a teacher or working for a non-profit charity. The trust can also supplement retirement income or help someone who suffers from a healthcare challenge that limits their ability to earn a living wage. If tuition and medical expenses are not being paid directly, the trust can pick up these costs.
What are some of the key things to consider when forming an annual giving trust?
Communication is critical! When considering forming an annual giving trust, we recommend that the donor connect with the trust’s beneficiaries to let them know what they hope to achieve by forming the trust. This call or in-person meeting should be reaffirmed with a letter to the beneficiaries. The letter serves as a reminder of why you are forming the trust and what you hope will be achieved by forming and funding the trust.
Setting expectations, transparency, and clarity are important. Whether you plan to give funds annually for many years or only for a few years, it’s good to set expectations so the recipients know the amounts they might look to for future support. We’ve seen good intentions lead to bad outcomes when the recipients of annual gifts were upset when the gifts stopped. There was no clear communication as to how long they could expect to receive the gifts and the recipients assumed gifts would be made each year for many years to come, so they didn’t save any of their gifts and came to depend on them.
If you’ve decided to pay for the college education for your nieces and nephews, we recommend that you tell them as soon as you’ve made the decision. We learned of a family who was told that their daughter’s uncle intended to pay for his niece’s college tuition and expenses at the niece’s high school graduation ceremony. Had he told them earlier, the family could have made different choices. They saved regularly to fund a 529 plan to pay for their children’s education. Instead, they could have contributed these funds to retirement plans. Or, they could have afforded to live in a better neighborhood with better public schools, offering their children access to a better education in their formative years. This last point is something that shouldn’t be lost on gift-givers. It’s amazing what can happen when a family is able to live in a better neighborhood, with top-notch public schools, where most children graduate from high school and go on to college and have productive careers from there.
We have seen first-hand how annual gifts to trusts so siblings, nieces, and nephews can live better lives, in better neighborhoods, with the ability to retire in a manner they might not have been able to afford can have a material beneficial impact on extended family members. The donor of these gifts hoped that by making such gifts, that his siblings, nieces, and nephews could make different career choices where they don’t have to worry as much about their income and can focus on careers that benefit their communities and which are more rewarding.
And equally important, when making annual gifts, it’s important to turn off your judgement. Once a gift has been given, don’t second guess the usage of that gift. You might consider limiting access to trust benefits with terms that prohibit distributions if someone has a drug or alcohol problem, or if they are giving substantial funds to a questionable use (such as a cult), but beyond a few such limitations, it’s often best to let the recipients make decisions for themselves as to how proceeds should be spent. The donor can always communicate their displeasure by not making future gifts. Experience has taught us that if you let others make their own decisions, you and they will be better served than if the donor continually judges how funds are spent.
What are some of the key rules to be aware of?
Proper administration is required. An annual gift must be a gift of a “present interest.” Whether a gift is given outright, or in trust, the recipient must be able to make immediate use of the funds. With gifts to an annual giving trust, donors must send a “Crummey” letter (named after the case that set this important precedent). The letter simply outlines the fact that the recipient has a certain amount of time to request this year’s gift from the Trustee. If they fail to do so within the time limit, those funds remain in the trust subject to the terms of the trust. Parents who serve as guardians for their children receive the Crummey Letters for their children, so minors do not need to be notified of annual gifts they’ve received.
Are there any changes to the annual gift rules proposed in the most recent tax legislation?
A key concern of many estate attorneys is that Congress may reduce the lifetime exemption (which permits an individual to give away assets in excess of the annual gift limit with no tax). The current limit is $11,700,000 per person. In addition, terms of trusts formed for the benefit of others may also be limited so that it is no longer possible for the grantor (donor) to pay the income tax bill for a trust they establish for the benefit of others.
One thing is not changing, however. And that’s the ability for individuals to make annual gifts to others, and to make those gifts to trusts where funds can be invested until they are needed. As the analysis above shows, this simple, yet powerful tool can pass on significant wealth to others with no gift tax.
We encourage you to ask your estate planning attorney about annual giving trusts. They may not have a super cool acronym, but they are super effective!
Disclaimer
This material is for information purposes only and for the use of the recipient. Under no circumstances is it to be considered an offer to sell, or a solicitation to buy any investment referred to in this document. Although we believe our sources to be reliable and accurate, we assume no responsibility for the accuracy of such third‐party data and the impact, financial or otherwise, it may have upon any client’s conclusions. Delegate Advisors, LLC has not audited or otherwise verified this information and accepts no liability for loss arising from the use of this material. The information contained in this document is current as of the date indicated. Delegate Advisors, LLC undertakes no obligation to update such information as of a more recent date. Any opinions expressed are our current opinions only. Nothing herein should be construed as investment, legal, tax or ERISA advice. You should consult with your independent lawyer, accountant or other advisors as to investment, legal, tax, ERISA and related matters to which it may be subject under the laws of the country of residence or domicile concerning the acquisition, holding or disposition of any investment in the account. Past performance is not indicative of future results. All investments involve risk including the loss of principal. Any investments discussed within this material may be subject to various fees and expenses, which will have a negative impact on performance.