6 Ways To Give Family And Friends Financial Aid
Updated Jan. 11, 2014 to reflect the latest gift-tax rates and limits on tax-free gifts.
Between the stock market roller coaster and the announcement of massive layoffs at corporate giants like Yahoo YHOO +0.36%, Pfizer and Hewlett-Packard HPQ +0.42%, many people are feeling pretty glum about their finances and wondering how they’re going to pay their bills.
If friends and family are among them and you have been more fortunate, you might want to help out. But did you know that the tax law regulates your generosity? This kind of assistance is considered a lifetime gift unless it’s for someone whom you are legally obligated to support, such as a child.
As far as the government is concerned, noble motives don’t matter; you must follow the same rules that would apply to any other lifetime transfers, including those intended mainly to pare down your estate and leave less for the government to tax.
The bottom line: Gifts of cash or other assets can count against your $5.34 million exclusion from gift or estate tax. If you exceed that limit, you could wind up owing gift tax of up to 40%. Even if you don’t, your lifetime gifts would reduce how much you can pass tax-free through your estate plan.
While generosity with family members often occurs under the radar, the law is clear: if the gift exceeds a certain value and the Internal Revenue Service catches it, you could be forced to pay the tax as well as interest, and, in some cases, penalties.
Here are strategies for subsidizing relatives and, in some cases, friends without having to pay gift tax.
1. Write a check for up to $14,000. The simplest way to subsidize others is by using the annual exclusion, which allows you to give $14,000 in cash or other assets each year to each of as many individuals as you want. Spouses can combine their annual exclusions to give $28,000 to any person tax-free.
For example, a married couple with a child who is married and has two children could make a joint cash gift of $28,000 to the adult child, the child’s spouse and each grandchild – four people – providing the family with $112,000 a year. Gifts that exceed this amount count against the $5.34 million ($10.68 million for married couples) lifetime exclusion.
2. Pay directly for medical, dental and tuition expenses. Without using your annual exclusion or dipping into the lifetime limit, you can pay for tuition, dental and medical expenses of anyone you want. Note that you must make the payments directly to the providers of those services – you can’t just reimburse the person whom you want to benefit.
This chance to pay for medical and dental expenses, often overlooked, can be enormously useful. For example, if someone you know is temporarily out of work and loses health insurance coverage, you could pay the premium for that person, or that person’s family.
3. Fund college savings plans. One way to apply a person’s portion of the annual exclusion is to put money in Section 529 education savings plans. Establishing these plans for relatives could relieve siblings or children of the need to save for college at a time when they are overwhelmed with current expenses.
You can set up a separate account for each family member whom you wish to benefit. Although your contributions to a 529 account are considered gifts, there are two unusual benefits: money in these accounts grows tax-free and can be withdrawn tax-free, provided it is used to pay for college, a graduate, vocational or another accredited school, or for related expenses. For a discussion of how this affects financial aid and other issues, see my Forbes magazine story, “Collegiate Confusion.”
4. Offer rent-free living. You can let someone live in your house or buy a house and let them occupy it rent-free, so long as the fair market value of the rent comes within the annual exclusion. Remember, spouses can combine their annual exclusion amounts, if necessary, to make the gift fit.
5. Employ friends and family members. Whether they provide child care, manage real estate or keep the books, the compensation you provide must be reasonable – not more than you would pay a stranger for the same work.
Paying a higher salary than you would pay outsiders exposes you to a potential double-whammy: Not only could you be personally liable for gift tax on the excess, but your company won’t be able to deduct the full salary as a business expense.
6. Lend and borrow money. Credit between family members requires the formalities of a bank loan, but the rate can be more favorable.
If you lend money to family members, you must charge a minimum rate of interest set each month by the Treasury, called the applicable federal rate, to avoid potential gift tax and income tax consequences.
That is less than family members would have to pay for a bank loan, assuming they could get one in today’s tight credit market, but more than you could earn from CDs or money market accounts.