Having recently become a father, this Tax Day has been a little different for me than in previous years. Intergenerational wealth – or the wealth that parents will pass on to their children one day – is top-of-mind.
So, I decided to talk to my company’s tax team about any potential tax implications that come with an intergenerational transfer of wealth. The conversation was eye-opening, to say the least. The landscape of tax exemptions and laws has shifted considerably in the U.S. over the last decade, especially when it comes to estate settlement.
Being aware of taxation laws and contribution limits is one of the best ways to provide financial security and support for your children without excessive tax deductions. We call this our “tax-smart” approach.
Tax laws are enormously complex, so while the tax-smart concept is simple, implementation is not. You need to choose the right strategies for your circumstances and goals. The two major options you have are providing for qualified education expenses and investing for your children.
Providing for Qualified Educational Expenses
Educational expenses have risen dramatically in recent years, but tax-advantaged options can help you pay for your children’s education without paying taxes on the amount spent. Helping your children pay for their education also sets them on the right path to building their own wealth.
Coverdell Education Savings Account
An Education Savings Account (ESA) is a great option if you want to provide for younger children up through college. The money in the trust account can be used tax-free for qualified primary, secondary, or college expenses. Contributions must be made after taxation, up to $2,000 per year per beneficiary, but are subject to income restrictions of $110,000 for single taxpayers and $220,000 for joint filers. When the beneficiary turns 30, any remaining funds must be paid out within 30 days, with earnings subject to a 10 percent penalty.
529 College Savings Plan
A 529 plan offers more flexibility than an ESA, but some funds may be used only for college. Contributions are tax-deferred with no contribution limits and no income restrictions. Money used for qualified expenses is not taxed, meaning that when used correctly, you can avoid paying any taxes on the money going in and the money coming out of the fund.
Educational Tax Credits and Deductions
In addition to an ESA and a 529 plan, you can also take advantage of tax credits and deductions for education. The American Opportunity Tax Credit enables parents to claim up to $2,500 in tax relief per eligible student, while the Lifetime Learning Credit may save you 20 percent on qualifying tuition expenses, not in excess of $10,000. Student loan borrowers may also be able to deduct up to $2,500 in interest on their loans.
Investing for Your Children
Education expenses, however, are not the only way to pass wealth to your children. Depending on your goals and funds, you may want to consider investment strategies that directly build wealth for your kids and minimize taxes.
Thanks to the Uniform Gift to Minors Act / Uniform Transfer to Minors Act (UGMA/UTMA), you can create a custodial account that allows tax-deferred savings until the beneficiary reaches adulthood and withdraws funds.
If you prefer to avoid taxes on earnings, consider a custodial Roth IRA. You can put up to $6,500 in the account per year, and the money can be used for college expenses, among other things. Your children will not be taxed when they withdraw funds at retirement, but early withdrawals will be subject to a 10 percent penalty.
Stocks and Mutual Funds
Every investment strategy has pros and cons. The ones I’ve mentioned so far tend to be lower risk, but you may want to consider investing in higher-risk, higher-reward options, such as stocks and mutual funds. Bonds will be likely more stable but generate less yield. If you are trying to balance risks and rewards, you could invest in funds that include a mix of stocks and bonds. Importantly, remember to diversify your investments.
Investing in Equities
Stocks, mutual funds, and ETFs can be great investments for passing on intergenerational wealth because they have the potential to provide significant gains over time. But you should bear in mind the tax implications of these investments. Higher yields mean larger taxes. But if your children fall within the 10 percent to 15 percent tax bracket, long-term capital gains taxes will be waived entirely.
Lastly, you could simply give money to your children. This approach can be a good option in some circumstances, but as I mentioned earlier, you need to keep in mind the tax implications. Creating a trust may help you minimize or avoid taxes when gifting, but federal gift tax rules set limits that you must follow to avoid penalties.
With careful planning, you and your children can benefit from building intergenerational wealth the tax-smart way. Just remember that you should always consult an experienced financial planner before making any firm decisions. A good advisor will be able to craft a strategy tailored to your needs while properly diversifying your portfolio to what is right for you and your family.