529

The Misunderstood Gift Tax: What You Should Know

When it comes to money and building wealth, the gift tax is often misunderstood. Let's drill down to the bottom of this "gift tax" and find out everything you need to know.

What is a Gift Tax?

The 2023 annual gift tax limit is $17,000 per person or $34,000 per married couple. What do these limits actually mean? It means that a person can give away $17,000 to anyone and to as many people as they would like without having to file IRS form 709 with their taxes.

The reason there is a gift tax is to prevent wealthy folks to give away large swaths of their money to avoid estate taxes at death. Gifting, however, is still a great way to reduce your estate tax limit if you happen to have that much money. The 2023 federal estate limit before incurring taxes is $12.92 million per person or $25.84 million per married couple. It’s also important to note that married couples can share this estate limit. When one partner dies, the other partner may have their $12.92 million plus whatever the other partner didn’t fully use.

What is a Gift?

So you understand the general premise of the gift tax, but there's another important piece of the puzzle: understanding how the IRS defines a gift. A gift is anytime there is a transfer of cash or property without receiving something of equal or fair market value in return. Many of us give gifts to friends, family, co-workers, and staff. But we don't generally buy gifts that cost more than $17,000 (if you do, let me know how I can be friends with you!). The gift limit generally applies toward family members. If Allison gives her son Tim a home that is worth $200,000, then she has given him a gift of $200,000.

While this scenario is unlikely, it is becoming more common for parents to help children with affording homes. Here's another scenario in which the gift tax matters: If Allison sells Tim a home for $50,000, but it is worth $200,000, then Allison gave Tim a gift of $150,000. Another gift scenario that many folks may not be aware of are loans to friends and family that are interest free or below the IRS Applicable Federal Rate. The IRS views these as gifts, not loans. So if you would like to loan money to a friend or family member, you must charge them a minimum amount of interest and report it on your taxes.

Married Couples and the Gift Tax

Married couples, rejoice! One notable perk of being married is the ability to give each other unlimited gifts to your spouse. This only applies, though, if your spouse is a U.S. citizen. If your spouse is not a U.S. citizen, then you are limited to giving them $175,000 a year (in 2023). But wait! Maybe you've heard there's a limit. This limit doesn't involve gifts between spouses, but rather when one spouse or the couple gives a gift to someone else. Here's how it works: The $34,000 per married couple gift limit comes into play when the gift comes from one spouse's bank account but is from the couple. For example, Carol and Jim are married. Carol gives $20,000 to her daughter Janet. $20,000 is over the $17,000 gift limit for an individual. So that would be an issue. However, since Carol is married, the gift can be from the couple and falls within the $34,000 limit. You are supposed to file this "split gift" on IRS Form 709.

The Gift Tax: Misunderstood

Notable Exceptions to the Gift Tax

There are exceptions to the gift tax limit. Phew! Here's some of the most common exceptions: We all know that donations to qualified non-profit organizations don't incur a tax. So do gifts to political organizations. Payments made directly educational institutions for tuition for private school, college etc. are also exempt from the gift limit. Another notable exception is direct payments for medical care. To recap, these exceptions include:

  1. Gifts to non-profit organizations
  2. Gifts to political organizations
  3. Tuition
  4. Direct payments for medical care

Children and the Gift Tax Limit

The gift limit mainly comes into play for us when it comes to funding our children's education. Many of us contribute to a 529 plan to pay for college. Did you know that your contributions to a 529, ESA, and perhaps a UTMA are all subject to the annual gift limit? One exception to the annual limit is the ability to frontload your child's 529 with 5 years worth of contributions. This means you can contribute $85,000 (5 x $17,000) or $170,000 if married (5 x $34,000) at once. You won't be able to contribute again for 5 years. Note: That this means you have used up the gift limit for all gifts, such as funding an ESA, UTMA, etc.

You're Unlikely to Pay the Gift Tax

Very few of us will ever need to worry about actually paying a gift tax. Even when you go over an annual limit and file IRS Form 709, all it means is that you are reducing your federal estate limit by the amount you over-gifted. In other words, a gift tax is not calculated until you die. In which case, you won't care about owing anything anyway.

What does this actually look like? Let's suppose that you gave your daughter Susan $50,000 and filed Form 709 for the $33,000 that was over $17,000 limit. This means that your federal estate limit is now $11.58 million MINUS $33,000. Clearly, there is still plenty left!

Final Thoughts on The Gift Tax

Tax law is complicated. The rumors and myths that swirl around it muddy the waters even more. However, most of us can breathe a sigh of relief. It would be unlikely for the gift tax to apply to us. Still, arming yourself with accurate information and making sure you know the exceptions to the gift lax laws should help you see through the speculation around gift taxes.

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Eggy May Have More Accounts Than You

if any, for your kid(s)'s education & life is a personal decision. There is no simple answer. I don't recommend doing any of these if your finances are not in order. Remember, there is no such thing as a loan for retirement. My 1 year old already has 3 accounts and about to open a 4th. Why? To take full advantage of time and compound interest of course. Here they are in order of when we opened them.

1. 529 College Fund

529s are the king of college savings accounts. You contribute after-tax money in, it grows tax free, and you don't pay taxes on withdrawal. You may even get a state tax deduction for your contribution. You can also open one before your child is born! So if you know you're going to have children and get a decent state tax break like I did when I was living in NYC, it's not bad a idea to get one going. Where should you open one? Start with your own state's plan. If you get a state tax break you'll want to find out if you're limited to using your state's plan to qualify for a deduction or not. A few states, including my now home state of PA, allow you to use any state's plan. So, I've kept mine with NY which currently offers the lowest fee Vanguard funds. We currently invest it all in the Aggressive Growth Portfolio which consists of 70% Total Stock Market Index Fund and 30% Total International Stock Index Fund. If your state offers no tax deduction then I recommend NY, Utah, or Nevada's plan. Pick Nevada if you already invest in Vanguard and want to keep things clean. Don't overthink it, just pick one. And – make sure you select the direct plan and not the plan via a financial advisor which are loaded with extra fees. There is a penalty if you withdraw money for non-educational purposes. Because of this I recommend saving something like 70% in a 529 and the rest in either a UGMA/UTMA or your regular brokerage (aka taxable account). There is a special rule allowing parents to frontload 529s above the gift tax limits. You may frontload 5 years worth (5 x $15,000 or $30,000 = $75,000 or $150,000). For those that can swing this, this is a great way to get that money growing for college.

2. UGMA (Uniform Gifts to Minors Act) 

UGMA & UTMA are basically savings and/or investing accounts for your children. You own the account as a custodian until junior reaches the age of majority. This age is state dependent but usually ranges from ages 18-21. Once they reach this age the account belongs to them and you lose control. Since this is an asset your child owns it will be counted for college financial aid calculations. The money can be used for anything. On the flip side, interest, dividends & capital gains are taxed. The taxation recently changed with the new 2018 Tax Law and will be taxed like trusts (15% & 20% tax above $2,600 & $12,700 respectively). Previously, the first $2,100 of unearned income (interest, dividends & capital gains ) was not taxed.

3. Coverdell ESA

Huh? That's the usual response I hear when I recommend this account for children. I already discussed how great ESAs and how you can fund one despite being over the income limit (kind of like the backdoor Roth IRA). You can only contribute $2,000 a year but over time (and compound interest) you can have a sizeable chunk of cash to use for either private school and college. Although there is a new ruling allowing up to $10,000 per year withdrawals from a 529 account for K-12, not all states have adopted this. I also don't recommend doing this unless 1) you get a nice state income tax deduction (like NY) and/or 2) you frontload your 529 at or near birth. Otherwise the money just won't have much time to grow if you keep withdrawing money from it. Unlike the 529 plan, you cannot open one before your child is born.

4. Roth IRA

[caption id="attachment_2545" align="alignleft" width="351"]Jack First Birthday Jack's Korean Dol outfit[/caption] We haven’t opened a Roth IRA yet but will before the end of this year. Children can open a Roth IRA if they have earned income. Chores around the house do not count. Babysitting and working for your business do. In Eggy’s case, he’s a print model for this website. What, you think he let me use this photo for free? Nope. A Roth IRA for your children via a family business is a win-win situation. You pay your child for work, you get a business deduction, he/she gets earned income and can open a Roth IRA. Once inside the Roth IRA, the money is never taxed again! Better yet – until he makes a sizeable income through the family business he won't pay federal and likely no state income taxes as well! Now, the key is to pay your child a reasonable wage for the work. It won't pass the snuff test if I paid Eggy $5,500 for a few photos on this website. A quick reminder to stay under the gift tax limits for total contributions to your children's 529, ESA, and UGMA/UTMA accounts. Currently, the gift tax limits are $15,000 or $30,000 for married couples. So, in other words, don't contribute more than $30,000 across the 3 accounts in a year. An exception to this is the 5 year frontloading exception for 529s. We opened and kept his 529 in NY. His UGMA and ESA accounts are at TD Ameritrade. We plan to open his Roth IRA at TD Ameritade since Vanguard does not allow minor Roth IRAs. What do you think? Comment below!  ]]>

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Part 2 of Making A Million Dollar 18-year Bet

This is Part 2 of Making A Million Dollar 18-year Bet, a guest post by Platinum Sponsor Johanna Fox of Fox & Co. Wealth Managementt, a fee-only financial planning firm. Start as early as you can As Bonnie says, compound interest is the 8th wonder of the world – you want to make it work in your favor. If you can afford to begin at birth, choose the most aggressive portfolio possible and contribute at least enough to get your state’s annual income tax break. Learn the rules in your state, too: some states allow tax breaks for contributions to other states’ plans and the cutoff for contributions vary: 12/31 in some states and 4/15 in others. Even if you can only afford to fund a minimal amount at birth, start with something as long as you are not compromising your retirement goals. In the Varkeys’ case, assuming 7.5% average return, choices include (not considering the time value of money):

  • Frontloading the 529 with $108,859 (because they are allowed to frontload $75k/person, they can split the gift and fully fund college). OOP savings = $384,801
  • Contribute $27,500/yr to the baby’s 529 for 5 years. OOP savings = $351,660
  • Make monthly contributions of $818/mo. for 20 years. OOP savings = $297,380

Use ESAs for lower grades

Our couple hopes to send their children to private high school. In this case, we recommend they add Coverdell Education Savings Accounts (ESAs) in addition to 529s. ESAs are often overlooked because:
  • Contributions are limited to $2k/yr per child and
  • Those with income over $190k are phased out from contributing (but you can get around this).
But by saving $2k/yr/child in an ESA from birth and averaging 7.5% growth annually, your ESA would be around $50k when your child is 14. Why is this important? Because under the new tax law, 529s can be applied to private school K – 12, but only up to $10k/yr [Editor's note: Some 529 plans aren't allowing this 529 K-12 withdrawal at all or require tax recapture ]. An ESA would be a nice complement to the 529. But what about the income limits? Anyone can contribute to the ESA – even the child herself. You simply gift $2k into your child’s UTMA each year and transfer it to the ESA. To avoid the UTMA, gift $2k to a trusted family member in a lower tax bracket and let them make the contribution.

Underfund your 529s and ESAs

This may sound contrary to the key principle “start as early as you can”, but please bear with me and it will make sense. My goal is to use up all of the money in your tax-blessed accounts. Otherwise, in general, you’ll pay a 10% penalty on funds you withdraw that are not used for approved education costs. There are exceptions to the 10% penalty, such as if a child gets a scholarship, but not for just having money left over. Of course, you can pass account leftovers down the line to younger siblings, and we plan to do that, but I’m trying to keep it simple – say, you don’t need as much because your children decide to start out at a community college or want to go to a state school with a best friend, or, even worse, follow a boyfriend or girlfriend there. How can you possibly plan for that? To mitigate that risk, we recommend that about 75% of projected expense goes into ESA/529s, with the remaining 25% going into a taxable investment portfolio. When following this recommendation, start the taxable account only after you have funded the 75% in 529/ESAs, which will maximize your tax-free funding. If you end up needing the taxable account, you’ll be able to take advantage of lower long-term capital gains and dividend rates. If you don’t need the taxable account for education, voila! Can you say “beach home?” So what about med/grad school – what should the Varkeys do? At this level of income with 3 children, they will probably need to raise their family in a LCOL area of the country, plan to work extra shifts for a few years (if that is an option), determine to be extremely frugal, or save to fund a less expensive college experience – after all, they are saving for 6 educations. Possibly forego the private high school. Or they could save only enough for 50% of med school (1.5 educations instead of 3.) Remember, planning is about prioritizing how to allocate limited resources to achieve your goals. We’re back to priorities – what are your priorities about lifestyle and education? It’s very important to get those figured out in the beginning rather than simply saving what’s left over in your bank account each month. For example, one of our clients in this very situation has opted to set aside enough for med school for one child using the 75%/25% rule. If one or both of the other two siblings also decide to be physicians, then we are planning to have enough saved in a taxable account to also send them. This couple lives fairly frugally and in a LCOL area.

Finally, invest aggressively if you can self-fund

Here’s the way I look at it – if you can cash flow the early years, particularly private K – 12, then you should keep your savings invested in a well-diversified equity portfolio up until the time you need it. If the market is down, we would plan to pay cash for private high school in this situation. If the market is climbing, we’ll liquidate enough of the 529/ESAs to pay the tuition annually. The 75/25 rule comes in handy again to prevent you from over-saving. And, of course, you can allocate your own savings any way you want: 60/40, 80/20, and so forth. By thinking through your choices, resources, and priorities, and then following your plan, you will have a much clearer path to saving for huge expenses that seem too far away to even think about when your children are young. I hope this information has been helpful!]]>

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Making A Million Dollar 18-year Bet

… (or Smart ways to fund your children’s education) This is a guest post by Platinum Sponsor Johanna Fox of Fox & Co. Wealth Managementt, a fee-only financial planning firm. Until recently, she was also our financial planner. Saving for college is on the minds of most of our clients since around 75% either have young children, are pregnant, or both. The amount you need to save for education depends upon the choice of college, how many children you have, how much your funds grow, and the percentage of college, grad school and/or med school you want to fund. For a family with even two young children, you can easily looking at a need of $1M – $2M by the time they are ready to start college, especially if you plan to fund post-grad. Of course, that’s not even considering private school for K-12. Planning ahead and doing it right will both save taxes and increase your long-term net worth. But planning so far into the future for little creatures with minds of their own is a daunting and expensive challenge. To explain how to build an education savings plan for your own family, let’s review a case study. I’ve built a composite family, the Varkeys, using details from several clients’ plans:

  • Dual physician family earning $680k/yr with children ages 2 and 6 plus another on the way
  • Want to save enough for 4 years at Georgetown University, their dad’s alma mater, and maybe medical school.
  • Hope to send children to private high school @$15k/yr/child.
  • Student loans of $150k, refinanced @3.875%
  • 2 mortgages: $850k on a $1.3M house and $450k on a rental duplex
  • One spouse has access to a 401k and the other has access to a 403b/457b combo, and they both do annual backdoor Roth IRAs.
  • And by the way: they hate debt
Let’s get some perspective about sending a child to Georgetown (or a similar school): the cost of attending today is $69,313/yr for tuition, books, room and board, and other expenses. By the time the baby attends, it will cost the Varkeys $493,660 in future dollars. This requires a plan! While we would need a lot more information to fully develop a financial plan, we’re using this case study to focus only on some key principles to consider when planning for education.

Prioritize

One of the biggest challenges of planning is prioritizing how to allocate limited resources to achieve your goals. The first rule in saving for education is not to sacrifice your own future: there are no scholarships for retirement and you will not be doing your children a favor by providing for nice educations at the expense of having to rely on them in retirement. However, you may be able to forego some retirement savings in the near term in favor of early education savings, and then get back on schedule. So, if your projections show that you will be able to skip a few years of 457b and backdoor Roth IRA contributions and have a few million dollars left at death, and that’s the only way you can fund your education accounts, then we might consider frontloading education to launch early tax-free growth and then return to maximizing all retirement space possible. Save for school or pay off debt? Since the debt feels so burdensome, I wouldn’t have a problem attacking the student loans heavily for 3 years but not the mortgage or rental interest. The reason is that student loan interest is not deductible, and lingering student loans are oppressive to many graduates because it represents nothing tangible. The interest on the mortgage is deductible as an itemized deduction and the interest on the rental will be deductible at some point – either when their rental begins to show a profit or when they sell it. And having tangible assets that are appreciating in value mitigates the emotional aspect of paying for “nothing”. Note: If you have access to an HSA, I would not forego contributing – ever (but that’s another article.)]]>

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I started a 529 account and I do not have a child

A great thing to do if you know you want kid(s) and are able to is to start funding their college account now.

Why? The cost of college tuition has been outpacing inflation at an astronomical rate. I started college in 1995 at Barnard College in NYC. Tuition at that time was ~ $20,000. 2016-2017 tuition is $48,614. That's over a 200% increase in tuition in about 20 years. I qualified for financial aid and only had $16,000 in loans when I graduated in 1999. Lucky indeed.

Of course, medical school was a different story and that tacked on another $150,000 in loans, but knowing how much other students graduate with now (> $300K !), I still consider myself quite lucky. I qualified for financial aid at Columbia and received a half tuition grant ($20K) and took out only Stafford loans and a private loan from Columbia funded by alumni.

The noose I feel around my neck from these loans is enough for me to want to not have this (entire) burden for my (future) kid(s). So much so that I started a 529 account NY in 2016. A 529 account is an account that you contribute post-tax dollars into that grows tax -free and can be withdrawn tax-free if used for qualified educational expenses. Kind of like a Roth IRA for education (which btw, you CAN use your Roth IRA for qualified educational expenses, but it should not be earmarked as such!) There are numerous 529 accounts and they are state sponsored.

NY is one of the states that allows a state income tax deduction on 529 plans (up to $5,000 per year). You can also benefit from this tax break even if you live outside of NY as long as you have NY income. So I am currently funding this account up to the state income tax max deduction per year. I expect that in about 5 years, I'll be able to increase that to $10,000 per year. I should have anywhere between $150,000-$250,000 in that account once said kid attends college. Time is on my side. Note that the annual limit to contribute to a 529 is limited to $14K per person or $28K per married couple to avoid possible gift taxes and for 529s, you can actually front load the account 5 years at a time.

I do not feel the need to fully fund their college education. Mainly because I may not be able to due to my late start at my own savings (as far as I know, there is no such thing as retirement loans) and I do want my kid to be grateful and have “skin in the game” for their education. I do not think most people appreciate things given to them for free. M and I also feel strongly that unless our kid gains acceptance to a top private school (aka Columbia, NOT Colgate) then they can go to state school.

Edit: You'll need to name yourself as the beneficiary until the kid is born.

Do you have a 529 account for your kid(s)? Are you planning on fully funding their college education? 

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