The end of the year is obviously a good time to assess one’s tax situation. Of course, many individuals often take it to the limit by waiting until the very last minute to implement tax-smart strategies—especially when it comes to making gifts to relatives and charities (besides, what better time to give than the holidays). Well folks, it’s now almost the last minute and the holidays have arrived. So here are some gift-giving ideas to consider:
Give Appreciated Securities to Relatives in the 10% and 15% Tax Brackets
For 2008, the federal income tax rate will be 0% for long-term capital gains that fall within the boundaries of the 10% and 15% federal income tax brackets. Great! This long-awaited development is about to become reality. So if you have children, grandchildren, or other relatives who will be in the bottom two brackets, giving them some appreciated stock or mutual fund shares before year-end could be a very tax-smart move.
Under the federal gift tax exclusion privilege, you can give away assets worth up to $12,000 during 2007 to an individual gift recipient without any adverse gift or estate tax consequences. In other words, such gifts won’t reduce your $1 million federal gift tax exemption nor will they reduce tyour $2 million federal estate tax exemption. A married couple can jointly give away up to $24,000 during 2007 without any adverse tax consequences.
If you are feeling especially generous, another $12,000 (or $24,000 if married) worth of appreciated securities could be given away in the first few days of 2008 without any adverse gift or estate tax consequences (the federal gift tax exclusion will remain at the $12,000 figure for 2008).
Even better, you can use this strategy to make gifts of appreciated LTCG property to adult children who can then sell the property and enjoy a 0% tax rate despite the fact they are doing quite well in the world.
Example 1: Fred, your adult child, is married with two kids of his own. If Fred files jointly and claims the standard deduction, he and his spouse can have a combined AGI of up to $90,000 in 2008 (including any taxable LTCGs from selling appreciated securities received as gifts from your client) and still be within the 15% federal income tax bracket ($90,000 of AGI translates into taxable income of $65,100, which is the top of the 15% bracket for 2008 joint filers). So, the LTCG tax rate is 0%. Better yet, if Fred wants to keep the securities, he can sell them and then immediately repurchase them so that his basis is now the stock’s FMV. (The wash sale rules do not apply to gains.)
A single adult child with no children who claims the standard deduction can have AGI of up to $41,500 in 2008, and still be within the 15% bracket ($41,500 of AGI translates into taxable income of $32,550 which is the top of the 15% bracket for 2008 single filers). As you can see, there will often be plenty of room to take advantage of the 0% tax rate on 2008 long-term gains from selling appreciated securities received by gift.
As a bonus, giving away appreciated securities will reduce the giver’s taxable estate while also allowing him to avoid any income taxes on the appreciation.
Warning: Unfortunately, much stricter Kiddie Tax rules will kick in for 2008, and they may impede the aforementioned appreciated securities gifting strategy for gift recipients who will be: (1) under age 19 at the end of 2008 or (2) under age 23 at the end of 2008 and a student for that year [IRC Sec. 1(g)].
Make Year-end Gifts Directly Paying Tuition Costs (or Medical Bills)
For those who would like to make year-end gifts that exceed the $12,000 annual gift tax exclusion, one option is to cover some or all of the intended gift recipient’s tuition costs (not room and board or other costs) by making direct payments directly to the educational institution. Such direct tuition payments won’t reduce the giver’s $1 million federal gift tax exemption nor will they reduce the giver’s $2 million federal estate tax exemption. Note that this break is available for K-12 private school tuition costs, as well as college tuition.
In addition to directly paying for tuition costs, up to another $12,000 can be given away in 2007 under the annual federal gift tax exclusion privilege ($24,000 for joint gifts by a married couple). Gifts covered by the exclusion privilege won’t reduce the giver’s federal gift tax or estate tax exemptions. As a bonus, the gifts will reduce the giver’s taxable estate.
Example 2: Erin’s 20-year-old grandson Eric attends an expensive private university. Erin would like to make a generous year-end gift to benefit Eric without dipping into her federal gift or estate tax exemptions. Here’s an idea. Before the end of this year, Erin could pay Eric’s $18,000 tuition bill for the 2008 spring semester (which starts in January) by writing a check directly to the university. (In most cases, tuition bills for the first academic period of 2008 will be due in late December or early January.) In addition, Erin could give Eric up to $12,000 of cash before year-end to cover his room and board and out-of-pocket expenses for the 2008 school year. The $30,000 worth of year-end gifts will not reduce Erin’s federal gift or estate tax exemptions (assuming she has not made any earlier gifts to Eric during 2007 other than gifts to directly pay for his tuition).
Note: The same favorable tax outcome also applies to direct payments to cover a person’s medical costs. As long as the payments go directly to medical providers, there are no adverse gift or estate tax consequences for the giver.
Make Year-end Gifts to Section 529 College Savings Plan Accounts
In general, contributions to fund another person’s Section 529 plan account qualify as completed gifts to that person for federal gift and estate tax purposes. As such, the contributions are eligible for the annual federal gift tax exclusion privilege ($12,000 for 2007 gifts). However, a beneficial special rule for Section 529 plans allows the giver to contribute a larger amount and then spread it out over five year’s for federal gift tax purposes. This effectively allows the giver to use five year’s worth of annual gift tax exclusions to shelter the contribution.
For example, the special rule allows up to $60,000 (5 × $12,000) to be contributed at the end of 2007 to a child’s or grandchild’s Section 529 plan account without reducing the giver’s $1 million federal gift tax exemption or the giver’s $2 million federal estate tax exemption (this assumes that no gifts to benefit that child or grandchild were made earlier in 2007 and that none will be made in 2008–2011). A married couple can jointly contribute up to $120,000 (5 × $12,000 × 2) to a child’s or grandchild’s Section 529 plan account without any adverse gift tax consequences (again, this assumes no gifts to benefit that child or grandchild were made earlier in 2007 and that none will be made in 2008–2011).
Section 529 plan contributions generally reduce the giver’s taxable estate. However, if a contribution is spread over five years under the special rule just described, a portion of the enhanced gift tax exclusion amount must be added back to the giver’s taxable estate if he or she dies before the end of the four-year period beginning with the year after the year of the contribution—i.e., before 1/1/12 for a 2007 contribution.
Make Year-end Gifts to Coverdell Education Savings Accounts
Contributions to fund another person’s Coverdell Education Savings Account (CESA) also qualify as completed gifts to that person for federal gift and estate tax purposes. As such, the contributions are eligible for the annual federal gift tax exclusion privilege ($12,000 for 2007 gifts). However, there’s a $2,000 annual limit on contributions to one or more CESAs set up for the same beneficiary (typically a child or grandchild).
For example, say you have five grandchildren. Before the end of 2007, she could contribute up to $2,000 to a CESA set up for each grandchild (total contributions of $10,000), assuming no contributions to their accounts were made earlier this year. As a bonus, CESA contributions will reduce the giver’s taxable estate.
Make Year-end IRA Contributions for Children or Grandchildren
If the client’s young child or grandchild has 2007 earned income, the client could make a cash gift that’s used to fund a 2007 contribution to a traditional or Roth IRA set up for the child or grandchild. The gift would be eligible for the $12,000 federal gift tax exclusion privilege. However, contributions to a child’s or grandchild’s IRA are limited to the lesser of: (1) $4,000 or (2) the child’s or grandchild’s 2007 earned income (the dollar limit will increase to $5,000 for 2008). Generally, a Roth IRA contribution will make more sense for a young child or grandchild because he or she may not gain any current tax benefit from a traditional IRA contribution.
For example, say you fund a $4,000 Roth IRA contribution for a 15-year-old grandchild. Assuming an 8% annual rate of return, the Roth IRA would amount to about $188,000 of federal-income-tax-free money by the time the grandchild is 65. Wow! As a bonus, the contribution will reduce the client’s taxable estate.
Make Year-end Charitable Contributions from IRAs
A beneficial change included in the Pension Protection Act of 2006 allows individuals who have reached age 70½ to make cash donations to tax-exempt charities directly out of their IRAs. These so-called qualified charitable distributions (QCDs) are federal-income-tax-free for donors. While a QCD won’t result in any Schedule A itemized writeoff, the tax-free treatment equates to an immediate 100% federal income tax deduction without any static from unfavorable rules that can reduce or delay itemized deductions for “normal” charitable donations.
There’s a $100,000 limit on QCDs for the donor’s tax year that begins in 2007. However, the QCD privilege will expire at the end of this year unless Congress extends it—which will probably happen, but you never know.
The IRS has confirmed that the $100,000 limit is based on a per-IRA-owner concept. Therefore, when a husband and wife both have IRAs, each spouse is entitled to a separate $100,000 limit (for a combined total of $200,000) even when a joint return is filed. The IRS has also confirmed that an IRA beneficiary (a person who inherits an IRA from the original account owner) can arrange for a QCD if the beneficiary is over age 70½.
As just explained, a federal-income-tax-free QCD is not included in the donor’s gross income or adjusted gross income, which amounts to a 100% deduction. Great! But there’s more.
· Because a QCD is not included in the donor’s AGI, he or she is less likely to be adversely affected by all those nasty AGI-based tax ripoffs—such as the rule that can cause more social security benefits to be taxed and the rules that can cut back itemized deductions (including those for charitable donations), personal exemptions, and passive rental real estate losses.
· Making a QCD also allows the donor to completely avoid the percent-of-AGI limitations that can postpone itemized deductions for garden-variety charitable donations.
· Perhaps most importantly, a QCD counts as a distribution for purposes of the required minimum distribution (RMD) rules. Therefore, an individual can arrange to donate all or part of the RMD amount (up to the $100,000 QCD limit) that he or she would otherwise be forced to receive and pay taxes on in 2007.
· Last but not necessarily least, making a QCD will reduce the donor’s taxable estate.
Observation: The QCD strategy can be beneficial for well-off seniors such as those: (1) who don’t itemize (under the “normal” rules only itemizers get any income tax benefit from charitable donations), (2) whose itemized charitable donations would be reduced by the IRC Section 68 phase-out provision and/or postponed by the percentage-of-AGI limitations, (3) who want to avoid being taxed on RMDs from their traditional IRAs, and (4) who are interested in estate-tax-reduction moves.
Donate LTCG Securities, but Sell Losers and Contribute the Cash
Last but not least, you should be advised that a charitable contribution of a LTCG asset (such as appreciated stock or mutual fund shares) generally results in a charitable writeoff equal to the full FMV of the asset and avoidance of any federal capital gains tax on the appreciation. So, making year-end contributions of long-term capital gain assets is generally a great idea.
In contrast, you should not contribute loser securities (those with current FMV that is less than tax basis). Instead, clients should sell losers, claim the resulting capital loss on Schedule D, and contribute the cash from the sales proceeds.