What’s next after planning your retirement? Help your children and grandchildren plan for theirs
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With both of these feats accomplished, you have the luxury of asking yourself, “What’s next?” Perhaps it’s time to consider preparing for your descendants’ retirements.
It may seem like a long way off, but it is never too early to start helping your family prepare for long-term financial security. I’m not suggesting that they be coddled. Rather, I’m suggesting that you provide a financial jump start to help them be more successful in their lives and careers.
Why is this important?
•The most common goal that I see among my retiree clients is their desire to make sure that their children and/or grandchildren will be in good financial shape.
•We are currently living in a period with reasonable Social Security benefits, relatively modest health care costs, and a relatively low tax rate (compared to historical tax rates). The future is less certain.
•Retirees today have benefited from a significant rise in the market dating back to the mid-’80s. While we cannot predict the future, many believe that returns for both stocks and bonds will be comparatively lower over the next 10 years then they have been in the past.
The traditional way we think about leaving assets to our children is through an estate plan and life insurance after we are gone. But, there are many reasons why it may be beneficial for both you and your children to make financial gifts while you are still alive.
One advantage of making a gift while you are alive is that your children can use the gift when they need it. I see many pre-retirement clients who are working hard to build up a significant amount of retirement assets through 401(k) savings plans, but who lack liquid assets to draw upon for spending today. Essentially, they are asset rich and cash poor. Helping them prepare for retirement may mean helping them bridge the gap, allowing them to achieve pre-retirement financial goals, such as buying a house, paying for college, or building a business.
In addition, as we continue to live longer and longer, waiting to transfer your assets via a will or trust may mean your children are well into their own retirements before they receive anything from you. Another benefit is that by giving during your life, you can watch your descendants benefit from your benevolence.
There are many important factors to consider when making lifetime gifts to your family. The annual gifting limit is $14,000 per person, per child or grandchild. This means that a couple can gift up to $28,000 per descendant without filing a gift tax return. You can certainly gift more than this amount, but you will be required to file a gift tax return and this will reduce your lifetime exemption. In addition, certain states have rules associated with estate taxes if the gift was more than $14,000 within a certain number of years prior to death.
During your lifetime, you can make a gift to your descendants in the following ways:
1.Gifting money so that a child is able to increase their savings inside a tax deferred or tax-free account.
2.Gifting money by opening up a custodial account you control.
3.Making an outright gift.
4. Gifting money so that a child is able to increase their savings inside a tax deferred or tax free account.
The first gift option available to parents and grandparents is gifting money so that a child is able to increase their savings inside a tax deferred or tax free account, such as a Roth IRA or Roth 401(k). Some common examples include:
Funding a Roth IRA
A Roth IRA is an account where the contributions are made after tax and the growth is tax free. This account works very well when future taxes are expected to increase. The contribution rules are similar to a traditional IRA, but with different income limits. The maximum contribution is $5,500 per year ($6,500 if over 50). You can gift money to a child allowing them to use that money to contribute to a Roth IRA.
For example, if your child is a teenager who earned $2,000 working a summer job, you could match the earnings by funding a Roth IRA for you child, gifting him or her $2,000 to open the account. The advantage of setting up a Roth IRA for your child today is that this account could grow to close to $23,000 in fifty years at a 5 percent annual growth rate. Please note that most children have absolutely no idea what a Roth IRA is. Not only are you giving your child a jump start toward financial security, but it is also a great opportunity to teach your child some financial planning basics.
Gifting to an adult descendant so that they can maximize their contribution in a Roth 401(k)
A Roth 401(k) is a type of 401(k) where dollars are invested after tax (as opposed to a traditional 401(k) where the dollars are invested pre-tax). If you are under 50, the maximum amount that can be contributed to either a traditional or Roth 401(k) is $18,000. If you are over 50, you can save an additional $6,000. At a 25 percent tax bracket, saving $18,000 in a Roth 401(k), would be the same as saving $24,000 in a traditional 401(k).
Gifting money by opening up a custodial account you control
The second lifetime gift option available to parents and grandparents is gifting to an account you control that will eventually go to the child. Some common examples include:
Opening a 529 Plan
A 529 plan is a specific account offered through states that allows for tax-free growth if the distributions from the plan are used for college or college-related expenses (called “qualified expenses” by the IRS). Saving for your descendants’ education expenses gives them a head start on their retirement savings by allowing them to start their careers with less, or even no, debt. They can immediately start contributing to their employee retirement plans, thus securing their own retirement, as opposed to having cash redirected towards student loans.
In addition to having tax-free growth, 529 plans help reduce your taxable estate and, depending on the state, may offer state tax incentives for the individual making the gift. In addition, the donor has control over the assets and can change the named beneficiary on the account. Donors need to be aware that the quality of 529 plans varies wildly by state — this includes fund choices as well as underlying expenses. Morningstar, as well as other firms, publish an annual survey of 529 plans. Finally, this gift is great for college education, but does not work well if the funds are used for another purpose. The reason being is that the income is then taxed at ordinary rates, plus there is a 10% penalty.
Opening a UTMA
A Uniform Trust to Minor’s Account (UTMA) is a taxable account that can be used to give money to a minor. One advantage to this account is that there is a little more flexibility than a 529 plan. And, a UTMA offers a tax advantage over an outright gift because the first $2,100 is taxed at the child’s tax rate. In addition, both the principal and income can be used at any age. A UTMA could allow a child, in the future, to draw on that account and allow him or her to put more money into their retirement account.
However, there are some disadvantages to UTMAs. The first is the so-called kiddie tax rule, which states that any income above $2,100 is taxed at the parent’s rate. The second problem is that once the child turns 21, the money belongs to him or her and can be spent in any manner (which may not be what the donor had in mind). Finally, for college financial aid, UTMAs are viewed as being 100 percent owned by the child, and thus can decrease the availability of financial aid.
Making an outright gift
Finally, if your descendant is no longer a minor, you can make an outright gift. An outright gift can be used in any way, at any time. It can help your descendants achieve current financial goals while still adequately saving for retirement. But, direct gifts are still subject to the $14,000 gifting limitations.
There are a couple of exceptions to the gifting limitations that allow for a parent or grandparent to give more than the $14,000 limit, specifically gifts for education and medical expenses. For example, A grandparent could gift $14,000 to his or her college-student grandchild, plus pay $30,000 for college — essentially gifting $44,000 in one year. But, the gift must be paid directly to the school or medical institution. Note that “school” is not limited to a university. The definition of medical expenses is a little broader and should be reviewed with your accountant.
If you are not ready to start giving to your family today, or if they are not ready to receive gifts, it is still prudent to ensure that your estate plan is in order. Going through a flow chart and making sure that your plan minimizes taxes while ensuring that assets flow the way you intend is critical. In addition, there are several tax advantages to gifting assets after your death.
A final strategy that can be used to transfer assets to your descendants after your death is life insurance. There are a number of benefits to holding life insurance above and beyond replacing income. Life insurance can make sense to offset taxes for those estates worth more than $5.49 million. Life insurance can also provide potential income tax savings, depending on the policy type. With some policy types you can calculate the expected rate of return at the policy inception to determine if life insurance is appropriate for your specific situation.
The downside to life insurance is the cost. As such, it is important to determine if the tax benefits outweigh the cost. Finally, there are psychological benefits to having life insurance including the peace of mind to comfortably spend down your retirement assets knowing that your descendants will be cared for.
At first glance, it may seem a bit premature to discuss planning for your descendants’ retirements, especially if your children or grandchildren haven’t yet started their careers. But, helping your descendants in such a way that they can eventually retire with dignity and live independently is a great gift to your family. While these gifts can be made after your death, there are a number of tax planning, wealth accumulation, and even psychological benefits to making gifts today. Communicating with your descendants about their challenges and your desires, and helping them build a long-term road map to success will be a lasting legacy to your family.
Seth Meisler, CFA, CPA/PFS, CFP, joined Affiance Financial in 2007 as the firm’s Chief Investment Officer. Today, he also serves as one of the firm’s principals. Meiser is also a member of Ed Slott’s Elite IRA Advisor Group.
The views represented are not meant to be construed as advice. Moreover, it should not be assumed that this content serves as the receipt of, or a substitute for, personalized advice from any other professional. Affiance Financial is neither an attorney nor an accountant, and no portion of this content should be interpreted as legal, accounting or tax advice.
Securities and advisory services offered through Private Client Services. Member FINRA, SIPC. Advisory services also offered through Affiance Financial, a Registered Investment Adviser. Private Client Services and Affiance Financial are unaffiliated entities.
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