It has almost become a cultural mystery for many Americans, but there is a good reason for it. Every November or December, certain families start getting checks from parents or grandparents in increments of $13,000 and no one really understands why. “Hey, isn’t this cool?” a twenty-one year old college student would tell their classmate. “My grandparents just sent me $26,000!”
When asked why, they would reply, “Oh, it’s some tax thing.”
While I like a good mystery, when it comes to tax planning things should be crystal clear. What is going on here is the grandparents are giving away money in amounts under the federal gift tax limit of $13,000 because their total assets would be above the estate tax limit if they passed on. A person can give away up to $13,000 per year to a non-spouse without having any gift tax consequences. In fact, they can give away as many $13,000 gifts as they want, but to different people. Conceivably, Bill Gates could give away $1 billion to in $13,000 increments to about 76,924 different people and have no gift tax implications.
While this is a great boon to some younger family members around the Holidays, is the gift really the best it can be? There is an amazing technique that can make that gift compound exponentially, especially for grandchildren.
While more and more teens and young adults are working while in school, nearly all of their money goes to paying expenses. Putting money aside for retirement is a distant thought because they are in an age group that is largely borrowing money just to get by and get an education. Their taxes are paid largely out of their paychecks, the rest goes to monthly expenses, and then the leftovers (if any) end up being spent. And so the large check in December from a relative would be a great “bonus” for them, but even if it is saved, it is probably put into a checking or savings account.
What if, instead of just writing them a check, you sat down with them to discuss their taxable income and offer to put aside an equal amount up to $5,000 in a Roth IRA for them? Now that money can grow TAX FREE for decades before they would ever need it.
OK, I can hear the grumbles of “that’s not how a Roth IRA works” starting, but follow this example through. Suppose 21 year old college student Kathryn is working for an ice skating rink teaching kids to skate, and she’s putting in about 6 hours a week during school and 30 hours a week during the Summer. She ends up making about $11,000 in 2010 before taxes. Because she is well under the maximum income level to put money away in a Roth IRA, she can put away up to $5,000 in a Roth. While Kathryn may not be able to afford investing $5,000 from her own paycheck because of the other expenses she has, there is no prohibition on her using money from another source to fund a Roth IRA such as a check from grandpa. The only prohibitions are that she can only put away $5,000, or if she earned less than $5,000 in that tax year then only up to the amount of earned income she did have. She’s already paying the taxes on her wages, which really means she is paying the taxes on the amount of money she is putting in a Roth IRA.
So what does this mean for Kathryn? It means that in 2049 when she is 70 years old that $5,000 growing at 8% interest is now worth $93,126.38… tax free! Let’s suppose that Kathryn’s grandfather gives her money for another 9 years and she likewise puts away the $5,000 in a Roth IRA each year. What does this mean to Kathryn in 2049? That becomes $725,462.07 for her retirement. And, again, it is tax free.
While there are still families out there giving checks to their children and grandchildren to help lower their potential taxable estate, those gifts can be given in a more tax efficient manner. Especially to younger adults who are paying income taxes and not putting away money of their own in a Roth IRA. Would you rather be remembered for a few checks given while the children or grandchildren are younger, or would you rather be remembered well into their retirement for helping fund hundreds of thousands of tax-free dollars for them?