Teaching your children and grandchildren to invest is an investment in their futures -- you're passing down the financial expertise you've spent a lifetime building. To that end, many parents and grandparents set up brokerage accounts for young family members to give them an early start on investing, and then work with them, sharing their experiences to help the novices avoid common -- and painful -- mistakes.
But the recent changes to U.S. tax laws have altered the dynamics with respect to multigenerational investment planning. Now, it will often make sense for older generations to hold onto appreciating assets, with the goal of helping family members to avoid paying taxes on gains.
The old way of dealing with wealth
Under previous law, wealthy families used to do everything they could to move wealth down to future generations as quickly as possible. There were a number of reasons for that:
- Estate taxes used to kick in at relatively low levels, with lifetime gift and estate tax exemption amounts of as little as $675,000 applying as recently as 2001.
- Steep differences in tax rates between higher-income parents and lower-income children often produced immediate tax savings from transferring taxable income.
- Some strategies involving gifts during one's lifetime produced greater potential estate tax savings than strategies available in an estate after death.
As a result, estate planning generally emphasized maximizing annual exemption gifts, having younger generations own assets that would appreciate in value the most, and finding ways to get discounted values for gift tax purposes on transferred assets.
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Why investing for heirs now makes more sense
The rules governing taxation have changed dramatically in recent years, and that's resulted in a shift in the best strategy for wealthy families to follow. Estate tax exemptions are now $11.18 million in 2018, allowing many wealthy families to escape estate taxation entirely. Gradual flattening of tax rates has made it less of a penalty for high-income family members to hold onto income-generating assets during their lifetimes.
Most importantly, the ability to obtain a stepped-up basis at death has survived multiple waves of tax reform. That essentially gives every member of the oldest generation the capacity to pass assets down to future generations in a way that can avoid up to $11.18 million in potential capital gains, depending on what your tax basis in those assets would be. Even at current maximum capital gains rates, that amounts to as much as $2.236 million in possible tax savings.
The way to implement this strategy is to hold assets in your own name, but invest them as though you were holding them on behalf of your heirs. That will typically result in a more aggressive investment strategy for these accounts, because younger generations will benefit more from higher-growth stocks and don't need to worry to the same extent about market volatility that an older investor usually does.
How this can save families tons of taxes
An example can show how this would work. Say that you're 80 years old and own shares of a stock that has already gone up 10 times in the 25 years that you've owned it. You want to provide for a grandchild who doesn't need money immediately but will have financial needs 20 years down the road.
In this case, you have a couple of options. You can give $15,000 worth of stock as an annual gift. Consider a couple of options: You can give $15,000 worth of stock to your grandchild now, or you can keep the stock, earmark it for your grandchild, and provide for it to pass to your grandchild at your death.
If you make the gift now, there's no estate or gift tax consequence. Say the stock then grows tenfold in the next 20 years, making it worth $150,000 in the future when the money is needed. Your grandchild will realize a $135,000 long-term capital gain when the stock gets sold, with current tax rates imposing as much as $27,000 in capital gains tax.
If you hold onto the shares, everything depends on when you pass away. If you die 20 years from now, the stock will be worth $150,000. But because the stock will get a step up in basis at your death, your grandchild will pay no capital gain tax at all on its sale. Again, in the past, holding onto a $150,000 asset in your estate would have led to draconian levels of estate tax. But because the estate tax is now almost a moot point for most families, returning to this strategy on a stepped-up basis is the smarter move.
Be smart with family taxes
Investing for your heirs has a lot of potential tax advantages, but it also addresses the most important thing of all for most older investors' peace of mind: ensuring that you won't run out of money. One of the biggest impediments to gift-based estate planning strategies is convincing clients that they can afford to make sizable gifts during their lifetime. Now that ideal estate planning has turned on its head for many families, maintaining control of assets longer can actually be the best move you can make.
