7 Estate Planning Tax Strategies & The 2003 Law

The 2003 tax law requires a re-assessment of family investing and Estate Planning strategies. New strategies might result in bigger family tax savings under the new law.

Under the 2003 law, the top tax rate on ordinary income is reduced immediately from 39.6% to 35% as of Jan. 1, 2003. In addition, the rate on long-term capital gains is cut from 20% to 15%. Even better, the rate on dividend income falls from a top rate of 39.6% to 15%.

These are big reductions, but income taxes might be cut even more if investment income can be shifted to children and grandchildren. The lowest tax rates on ordinary income now are 10% and 15%. Even better, in these lower brackets the tax rate on long-term capital gains and on dividends is a mere 5%. (Another change affects the lower capital gains rates imposed on property held for at least five years, that I reported most recently in the May 2003 issue. These lower rates effectively are repealed and replaced by the new rates.)

Clearly, with the difference between the highest and lowest brackets there still are significant benefits to shifting income to the youngsters. More importantly, the low rates might require a fresh look at the use of some popular tax-advantaged vehicles such as Section 529 plans.

For single taxpayers, the 10% bracket applies to taxable income (after deductions and exemptions) up to $7,000; for married couples the bracket ends at $14,000.

The Kiddie Tax provides special rules for taxing youngsters through age 13. For any dependent under age 14, the first $750 (indexed for inflation each year) of income and gains is tax free. The next $750 is taxed at the child’s tax rate, either 5% on long-term capital gains and dividends or 10% on other income. Any income above $1,500 is taxed at the parents’ top rate. Once the child hits age 14, however, all income and gains are taxed at the child’s own rates.

These rules and the new tax rates open up some profitable planning opportunities. Here are the new strategies for splitting income among family members to minimize taxes.

Estate Planning Strategy #1

Limit income until age 14. Under the Kiddie Tax rules it can be profitable to transfer a relatively small amount of investment income to a young child or grandchild, but there is no benefit to transferring too much income. Any investments in the name of a child under 14 should be structured to limit dividends, interest, and capital gains so they are not taxed at the parent’s rate. Invest for growth until the child is at least 14. That means buy stocks that pay little or no dividends. Or invest in mutual funds that traditionally have low or no annual distributions. Buy only stocks or mutual funds that are unlikely to be sold until the youngster is age 14 or older.

Estate Planning Strategy #2

Shift bonds to youngsters. No one gets a tax benefit on bond interest income. The interest is taxed at ordinary income rates. There can be very significant tax savings, however, by shifting interest income from a top-bracket adult (35% rate) to a youngster (0% to 15% rate). If a family is holding a diversified long-term portfolio for the child’s benefit, it might make sense to have the bonds held in the child’s name while other investments are in the parents’ or grandparents’ names.

Estate Planning Strategy #3

Give appreciated property. Parents or grandparents can invest for growth in their own names until a child or grandchild needs money. Then, the family can reap substantial tax benefits by transferring the appreciated property to a youngster who is age 14 or older and having the youngster sell the property. While the adult selling the property would pay a long-term capital gains tax of 15%, the youngster one of the lowest two brackets would pay taxes at only a 5% rate. On a $10,000 gain that drops the family tax bill from $1,500 to $500.

Before giving, you want to be sure that the gains plus any other income of the youngster won’t push his or her income above the limit for the 15% bracket. If it does, there is no tax advantage to the transfer.

Of course, once property is given to the youngster, it is his or hers. If the child is at least the age of majority (18 or 21, depending on the state), he or she can do anything with the wealth. Before that, the money can be put into a custodial account and managed by an adult for the child’s benefit. But with the custodial account, once again the youngster gets full control of the property at the age of majority. In addition, money in a custodial account cannot be spent on a legal support obligation of the parents.

Estate Planning Strategy #4

Reconsider Section 529 plans. These college savings plans have been extremely popular since their creation in 1997. Money is invested in an account in the future student’s name. Income and gains earned by the account are not taxed. If money is distributed to pay for qualified education expenses, the distributions are tax free.

Perhaps best of all, the donor of the account still retains some control. The beneficiary can be changed. The account can be shifted to a different state’s plan. The donor even can get the money back if it is needed.

The lower tax rates dim some of the luster of 529 plans. A taxable account in the parents’ or grandparents’ names won’t get the 0% rate of a 529 plan. But if dividends and long-term capital gains are the only investment income in the account, the maximum tax rate is only 15%. In addition, taxes can be deferred by letting gains in stocks and mutual funds compound tax deferred until the money is needed. Further, the taxable account will have unlimited investment options instead of the limited choices imposed by a 529 plan. You also can structure and invest a taxable account so that it has lower fees than a 529 plan. The fees could be much lower if the taxable account is invested in no load mutual funds. The 2003 tax law reduces the tax advantage of the 529 plan. The total control over the taxable account plus its flexibility and lower cost might make up for the lower taxes of a 529 plan.

Estate Planning Strategy #5

Don’t forget financial aid. College financial aid will be more significant than tax savings for many families. Determine if the future student might be eligible for financial aid. If he or she might be, it makes sense to keep money out of the child’s name despite any tax benefits of family income splitting.

When financial aid is computed, the formula assumes that most of the wealth in the student’s name will be spent on education expenses. A much smaller portion of wealth that is in the parents’ names will be used to reduce an aid award. No wealth in a grandparent’s name will be used to reduce financial aid. An adult who wants to maximize financial aid for a youngster and who wants control over the wealth should avoid transferring money to a child’s or grandchild’s name.

Estate Planning Strategy #6

Truly long-term planning. Most reports about the 2003 law have not noted that in 2008 for one year only the lowest tax bracket drops to zero for all income. That’s right. Those in the lowest tax bracket will pay 0% tax on ordinary income, dividends, and capital gains realized in 2008. If the law doesn’t change, that would be a good year to shift some appreciated property to a grandchild or child and have it sold. Be sure that the child doesn’t earn enough income to exceed the lowest tax bracket that year.

Estate Planning Strategy #

Don’t forget gift taxes. Remember that any transfer from one person to another is a gift. Each person can give any other person up to $11,000 annually (indexed for inflation) free of gift taxes. A married couple can give jointly up to $22,000 annually per individual donee. Gifts above that amount each year reduce the giver’s lifetime estate and gift tax exemption. If the lifetime exemption is exhausted, gifts above the annual exemption are taxed.

Most parents and grandparents should take a multi-year approach to helping a youngster. In the first years, investments should be kept in the adult’s name. The adult can invest to minimize taxes. Avoid interest income and short-term capital gains, and earn primarily long-term capital gains and dividends. Later, after the child is 14 or older, the adult can decide if it makes sense to shift all or some of the investments to the youngster.

There isn’t even a need for the property to be in the child’s name for long. As money is needed, give appreciated property to the youngster. He or she can sell the property and pay the lowest long-term capital gains tax rate. This way, the property can be controlled by the parent or grandparent until the child needs it, say, when a tuition bill is due. Then a gift of enough to property pay the child’s expenses plus the taxes can be given.

The 2003 tax law requires parents to take a fresh look at the strategies they use to help children and grandchildren. It might be easier now for many families to reduce overall taxes while increasing the help provided to future generations.