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Why financial planning is essential if you want to help your friends and family get by during COVID-19

Helping family financially during the coronavirus pandemic is an admirable thing to do. Before making that decision, though, it’s important to think through your options carefully and understand the tax implications of any gifts. In 2020, you can gift up to $15,000 free of tax to an unlimited number of recipients. A gift of more than $15,000 doesn’t necessarily mean that you will owe taxes.

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As the COVID-19 pandemic continues to send shockwaves through the economy, millions of people are facing financial distress. Some are turning to family members for financial help, and some are seeking government assistance. To help struggling Americans, the Coronavirus Aid, Relief, and Economic Security (CARES) Act allows penalty-free withdrawals of up to $100,000 from 401(k) accounts.

This may be a viable way to make ends meet, but it should be a last resort for people strapped for cash. While the CARES Act removes the 10% penalty, the distribution is still subject to income tax. The more significant expenses, though, might be the missed opportunity of tax-deferred growth in a tax-advantaged account and the forced sale of long-term investments in a bear market — especially because stock market returns following a bear market tend to be robust. Ultimately, early withdrawal can put retirement, a critical financial goal, in jeopardy.

If you are financially stable but have loved ones dealing with financial difficulties, you may consider offering them support so they can avoid tapping into their retirement money early. Helping family members financially can be a great option, but it’s something you should consider carefully.

Exercise moderate caution

Before thinking about how to help family members with financial problems, first assess whether you’re truly capable of assisting. Review your finances to ensure you have enough assets available — and ones that can be converted to cash without triggering hefty tax penalties.

If you truly are in a position to help family members with money problems, proceed with care. Finances are a sensitive matter, and your eagerness to help could be misinterpreted.

Before you show up with a check, talk to your family members to understand whether they legitimately need — and want — financial assistance. If they need aid, then be clear that you empathize and are there to help and not to judge. Putting conditions on how they can use the money may make them feel belittled. Instead, listen and help them decide what to do with the funds. This will empower them and make them feel in control.

Finally, you should decide in advance whether you’re making a gift or a loan. If you do plan it as a loan, is it going to be a problem if they can’t pay you back? Even if your family is struggling with money, the last thing you want is for your help to create tension down the road. Decide on a firm number and any repayment expectations ahead of time. This will help both you and the person you are trying to assist.

Understand the Gift Tax Laws

Helping family members financially can take many forms, whether it’s parents helping children, siblings supporting each other, or children taking care of their parents. If your family is having money problems — and you decide to help — it’s essential to consider potential tax implications. If you have any questions or concerns while reviewing the gift tax rules, meet with a tax professional for guidance.

In 2020, you can gift up to $15,000 free of tax to an unlimited number of recipients. For example, a married couple helping their child can give $30,000 using the annual exclusion since each spouse is eligible to gift $15,000. If the child is married, then the same couple can give $60,000 in total. Any amount over those limits — whether it’s in the form of cash or material gifts — is a taxable gift that must be reported to the IRS via a gift tax return (Form 709). The person giving the gift is liable for the gift tax (not the recipient), and the tax rate can be as high as 40%.

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A gift of more than $15,000 doesn’t necessarily mean that you will owe taxes, however. You can apply any gift above the annual gift tax exclusion to your lifetime exemption, which is $11.58 million in 2020.

For example, if you gift $50,000 to someone, the first $15,000 will go against the annual gift tax exclusion. The remaining $35,000 is a taxable gift, but it can be deducted from your $11.58 million lifetime exemption to avoid paying any gift tax. Remember, though, that you still have to file a gift tax return.

Avoid taxes entirely with education and medical expenses

The best strategy for helping your family with money problems will depend on your specific situation. Still, there are a few guidelines to help you maximize your gift while minimizing your taxes.

One of the areas where the gift tax limit does not apply is medical expenses. There is no cap on how much you can give to help with medical bills — as long as you pay the hospital or caregiver directly. Giving money to your family members first is a taxable event, even if you intend for them to use the money to pay medical bills.

Another area that receives special gift tax treatment is education expenses — particularly tuition. Similar to medical expenses, the gift tax limit does not apply as long as you pay the school directly. However, educational expenses such as books, supplies, room and board costs, etc., do not qualify for the exclusion.

One way to gift more than $15,000 in one year to help with other educational expenses is through a 529 college savings plan. The IRS allows an accelerated gift of up to five years’ worth of the annual exclusion to a 529 plan. That means you can gift up to $75,000 to each beneficiary’s 529 plans in 2020. The beneficiary can use the account immediately for other expenses, like room and board, or invest the money and allow it to grow. The account works much like a Roth IRA — the growth is tax-sheltered, and the distribution is tax-free as long as it is used for qualified educational expenses.

Be smart about how you give

If neither of the above situations applies to you, there are still several ways to minimize your gift tax impact when helping family members financially:

1. Break up your gift.

If the gift can wait a few months, split it up so that you are not giving over $15,000 in any one calendar year. Instead of offering a lump sum of $25,000 now, for example, you can gift $15,000 now and another $10,000 in January 2021.

2. Be strategic with capital gains.

If you sell an investment and gift the money, any earnings you made on those investments would be subject to capital gains tax. If your family members are in a lower tax bracket due to the impact of the coronavirus, though, you can use this to your advantage.

For example, consider gifting stock directly since capital gains rates can be lower — even zero — at lower incomes. Capital gains tax rules differ by state, so make sure to check the laws before deciding whether this is an appropriate option for you.

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You also should beware of the Kiddie Tax. Under this rule, gifts to children under age 24 can be subject to their parent’s tax rate on investment assets.

3. Structure the gift as a loan.

If you are thinking about helping family with money problems with a loan instead of a gift, then the gift tax won’t apply. However, the IRS has strict guidelines on determining whether something is a gift or a loan. There are a few steps necessary for your loan to qualify in the eyes of the IRS:

  • Get a loan agreement and fixed repayment schedule in writing.
  • Don’t schedule a time at which you plan to forgive the loan.
  • Secure the debt with some collateral.
  • Charge the minimum interest rate, known as the applicable federal rate, or AFR.

The IRS publishes the AFR each month, so be sure to check the current rates at the time of your loan. Currently, the AFR is very low: As of May 2020, it is 0.25% for a short-term loan of three years or less and 1.15% on a loan of more than nine years.

4. Use your lifetime exemption.

As mentioned earlier, gifts above the $15,000 limit in a given year can be applied toward your lifetime exemption. Keep in mind, however, that the lifetime exemption amount you use for a gift you make while you are alive will offset your estate tax exemption on the inheritance you can give when you die, dollar for dollar.

That being said, most Americans are unlikely to need the full $11.58 million exemption ($23.16 million for married couples) over their lifetimes. It is a best practice to avoid tapping into the lifetime exemption if you have assets of more than $5 million when helping family members financially. Lifetime exemptions have changed over time, and Congress could always decrease them in the future. In fact, without further action, the current lifetime exemption amount is set to revert to about half of its current value beginning on Jan. 1, 2026.

If you’re financially secure and wondering how to help family members with financial problems, you’re in a great position during a challenging time. Before you give, though, make sure you think through the implications and plan the best way to maximize your gift for both you and the recipient.

(Featured image by edar via Pixabay)

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Daniel Lee CFA, CFP®, is a financial planner dedicated to helping busy people make intelligent financial decisions by providing clear, straightforward advice free from conflict of interest. He is currently the head of Plancorp’s San Francisco office. Plancorp, is a full-service wealth management company serving families in 44 states. Daniel is an award-winning instructor at UC Berkeley Extension and is a member of the CFA Society of San Francisco and the National Association of Personal Financial Advisors (NAPFA).