O.K., so you're willing to provide monetary assistance to your adult children. Here are some ways to do it that preserve wealth and minimize tax liabilities
Editor's Note: This is an updated version of a story that was originally published on Nov. 5, 2007.
Talk to people between ages 55 and 65 and they'll tell you: An empty nest doesn't necessarily mean you've stopped doling out worms to the youngsters.
Part of the reason older parents still provide financial assistance to young adults stems from the escalating cost of living, particularly when onerous payments on education loans deplete huge chunks of twenty- and thirtysomethings' salaries. Most people fresh out of college find it hard to afford the rent without help from home.
But another factor may be unique to the sensibility of the baby boomer generation. "The boomers' tendencies lean toward doing whatever it takes to take care of our kids. We do a lot for our kids," says Steve Slon, editor of the American Association of Retired Persons' bi-monthly AARP The Magazine. "When we see the cost of housing and education, we just get out our checkbook."
Researchers at the University of Michigan's Institute for Social Research reported in 2004 that 34% of adults between the ages of 18 and 34 receive financial assistance from their parents, and that the average total contribution during those 17 years is $38,340.
For most parents, the decision to help their grown children financially is too emotionally loaded to be bound by considerations of financial prudence, says Anthony Benante, a financial adviser at Baron Financial Group in Sarasota, Fla. "In our general experience, parents who want to help their kids are going to help them," he says. "And then you figure out how to do it."
Only when a request for help becomes a recurring need will his clients of retirement age seek out financial advice about the most cost-effective ways to provide support, Benante adds.
The basic building block of funding grown kids is a cash gift, which isn't subject to federal gift tax as long as each parent gives no more than $12,000 per year to any child or other family member. Parents whose gifts exceed that amount don't have to pay the taxes on the surplus right away. Instead, they are tallied against a uniform credit that is currently $1 million during a person's lifetime and an additional $1 million applied against the estate after death. The total uniform credit is scheduled to rise to $3.5 million in 2009, with the lifetime portion remaining capped at $1 million. (Read more on gifting strategies.)
J. Patrick Collins, a principal at Greenspring Wealth Management in Towson, Md., says he expects many clients to ratchet down their gifting compared with prior years due to constraints caused by the financial meltdown.
"There's less opportunity to gift appreciated stocks. Anyone who's bought something in the last three or four years is not getting a big tax benefit," he says. Gifting stock at this time is worthwhile only for people sitting on stocks they bought 30 years ago that have a low tax basis, he adds.
What's less widely known is that parents can also directly pay their children's expenses—anything from rent on an apartment and medical bills to grandchildren's tuition. As long as they're paid to the billing institution, they don't count toward the annual gift-tax exclusion or the lifetime credit. The definition of medical expenses is fairly expansive and includes hospital visits and even health insurance. These kinds of payments can save parents from worrying about whether their kids' medical or other basic needs are being taken care of, Benante says.
Inevitably, some children take advantage of their parents' willingness to offer financial support, while some parents all too easily fall into the trap of enabling their children's dependent behavior, he says.
When Benante meets with such clients, he alerts them to what's happening to their portfolios. Some parents may not have that much financial wiggle room. "We have to let them know they're eroding their retirement [savings] sooner than they think if they pay at that rate."
With the estate tax set to expire in 2010 and then return in 2011, calculating how much money parents can afford to give their children beyond the annual limit is complicated. The issue, a political football, probably won't be resolved until the new Congress and President take office, says Jerry Chasen, an estate tax attorney in Miami.
Given how depleted the federal government's coffers are by the financial rescue program, the chances that the stronger Democrat-controlled Congress will allow the estate tax to sunset in 2010 are slim to nil, some planners say.
In making financial plans, it's important that parents be clear about what they want to accomplish and pick a structure appropriate for the goal, working out the tax benefits around that, says Chasen. "The tax tail shouldn't wag the goal dog."
While the collapse in stock prices has virtually eliminated any tax benefit gifting stock would have provided, this is an optimal time for parents to convert their much diminished IRAs into Roth IRAs to be passed on to their children in the future, says Frank Armstrong, president of Investor Solutions in Coconut Grove, Fla.
"You can transfer a lot of money [for relatively low cost]. When [the stocks] appreciate, kids get all the appreciation forever tax-free," he says. "That's a tax strategy that works very well in today's environment."
An alternative to gifting is the outright transfer of property, including cash, to a son or daughter in exchange for annual income payments for the rest of the parent's life. A private annuity, which is set up as a contract among the parties involved without using a financial intermediary, uses IRS actuarial tables to calculate annual payments but avoids the fees by cutting third parties such as insurance companies out of the process, says Frank Armstrong, president of Investor Solutions in Coconut Grove, Fla. It can be used to finance a child's business venture or a down payment on a home.
There's no tax advantage in transferring money for estates worth less than a couple million dollars, though the annuity does provide an income. Annual payments, when they come in, are treated partly as a return on principle, which isn't taxable, and partly as ordinary income, Armstrong says.
Private annuities are fraught with problems, however, and aren't used very often, says Charles Aulino, director of financial planning at Glenmede Trust, outside Philadelphia. The key advantage is that upon a parent's death, the child's responsibility to make annuity payments is extinguished. If the parent lives well beyond his or her projected lifespan, payments can exceed the value of the originial assets received, he says.
For parents whose kids have a well-developed sense of civic or social responsibility, setting up a family foundation can be a great way for the entire family to fulfill common philanthropic goals.
Parents need to ensure, however, that there isn't even the appearance of funneling money to children who aren't in fact going to do any work toward the foundation's stated goals, Chasen says.
The most cost-efficient way to set up a family foundation is with a donor adviser fund (DAF), administered by an outside entity, usually a mutual fund company such as Vanguard or Fidelity Investments, says Greenspring's Collins. The administrator takes care of all necessary tax filings to the IRS and grant distributions to selected charitable organizations for a fee that's typically 1% of the fund holdings.
For someone who wants to give away $25,000 or $50,000, a DAF is a much cheaper alternative to establishing a family foundation, where the administrative, legal, and accounting costs alone eat up the bulk of the invested assets, Collins says. "You don't even want to start looking at [a self-created family foundation] until you have $1 million to $2 million to put into it."
After making the initial contribution, the family has a menu of options similar to a 401(k) plan that allows it to choose between aggressive, conservative, or balanced investment vehicles. Collins likes the American Endowment Foundation, whose open architecture lets donors choose any investments they want, including individual stocks.
In addition to themselves, parents can give grown children control over making grants and can also name successors to take control after their deaths. Each year, the family would meet to decide how that year's contribution is used. The DAF cuts the check, sends it out, and files the required paperwork.
Family foundations can also serve as a tool for teaching children a sense of financial responsibility, laying the foundation for a healthy attitude about money matters throughout their lives, says Collins.
A Family Business
A parent who wants to transfer a portion of a business to a child can set up what's known as an intentionally defective grantor trust, which purchases an interest in the business. The income from the trust can either be distributed as it's generated or held until a grown son or daughter is ready to manage it, Chasen says. While it's a complete transfer for estate-tax purposes, the senior generation is still responsible for the income tax liability.
Setting up the trust doesn't have to entail transferring operational control of the business, Chasen points out. Once the parent dies, the trust is no longer treated as a grantor trust, but how it gets taxed by the government from that point on still isn't clear. The trustee the parent appoints to run the trust could be a sibling, a close friend, or a professional trustee. The costs to set up and run it are questions that each grantor needs to ask when talking with a prospective trustee.
There is no one-size-fits-all rule for setting up this kind of structure. "The question is what is appropriate for these people, given their values, their intentions, their risk comfort level, and the assets that are involved," he says. It's important that, he adds, that parents work with financial advisers who know what they're doing and who take the time to get to know their clients.
To bring down the taxable portion of an estate, parents can put life insurance policies into a trust, says Glenmede's Aulino.
There are also tricks to turning the $1 million lifetime gift limit into more money that's equally protected from the gift tax. One popular strategy is to set up a simple lifetime gift trust, to which both a husband and wife contribute their entire $1 million lifetime gift exclusion allowance, ideally well before they retire.
"If you live for 15 to 20 years from now, that $1 million can generate another $4 million to $5 million, which is also excluded [from your uniform credit]. People in their fifties can see that multiplied while they're alive, so they can have the satisfaction of knowing the government can't touch [it] with a 10-foot pole," says Aulino.
Beyond the purely financial issues, estate planning can also be used to pass down values and life lessons to successive generations.
Chasen routinely has his clients prepare a personal legacy statement. Though not strictly a legal document, it allows parents to stipulate certain conditions for an inheritance. One of his clients was a matriarch whose children had a lot of hostility toward each other. In her legacy statement, she said it would hurt her to know she had failed as a parent if her kids couldn't find a way to get along with each other after she died.
One point that Chasen never tires of making is that financial planning is about more than just the treatment of assets. It's not just about the money, he says. You have to take "into account the human beings that are involved."