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Strategies for Making Tax-Free Gifts to Loved Ones

Prospective insurance buyers are often confused about disability income insurance because the features and benefits can vary widely from one policy to another. Essentially, there are a few key elements that could make a big difference when you make your choice. If you are in the market for disability income insurance, here are some significant points to consider:

If you have substantial assets, you may already be making regular tax-free gifts to your loved ones. But giving cash is only one way to transfer assets tax free to family and friends, while reducing your total assets to minimize the possibility of gift taxes.

Recent U.S. tax legislation permits an annual gift tax exclusion amount that you can give ($13,000 or $26,000 for gifts made jointly by husband and wife in 2011) to an unlimited number of individuals without owing gift taxes on the transfer. Even with the annual limit, the total you can transfer tax free to loved ones could be substantial. For example, if you and your spouse each give the maximum tax-free amount to your son, daughter-in-law, and three grandchildren, you can transfer $130,000 to their household in a single year.

A lifetime gift tax exemption in 2011allows you to gift $5 million ($10 million for a couple) throughout your life without incurring gift tax liabilities. However, this exemption reduces the amount that you, as a taxpayer, can give away tax free after your death.

If some of your beneficiaries are young children, gifts may be placed in custodial accounts that are managed by the parents. Or, you could deposit gifts to grandchildren directly into a 529 plan, which is an account specifically for education expenses. With 529 plans, you are permitted to make lump-sum gifts of up to $65,000 ($130,000 for joint filers) per child, which represents five years of giving; however, you would be unable to make tax-free gifts on behalf of the same child for the next five years. The funds in these accounts have the potential to grow tax free. Distributions are also tax free, provided they are used to pay for qualified education expenses.

As an alternative, you could make direct payments to educational institutions for tuition only, and these gifts would not be subject to the gift tax. For example, if you have selected a private school for a grandchild, you could arrange to pay the first several years of tuition in advance. To ensure that the money is not lost if the child does not attend or leaves the school, the school may agree to transfer the funds to another school under specific circumstances. When structured properly, this arrangement can save money by locking in lower tuition rates, while also making it possible to transfer funds on a tax-free basis.

If a loved one has substantial health care expenses, you may make tax-free payments on medical bills, including costs related to diagnosis, cure, mitigation, treatment or prevention of disease; transportation essential to medical care; prescription drugs; and premiums for medical insurance. These contributions can be especially helpful if a loved one sustains a disability and requires continuous care. However, for these transfers to remain tax free, payments must be made directly to the medical provider, rather than to your loved one.

Another option for transferring money to a family member, while minimizing taxes, is to loan money, rather than gifting it outright. This strategy may be appropriate if, for example, an adult child needs a large amount of money to start a business or purchase a home. Note that in 2011, if you are the lender, you are required to declare the interest income on loans exceeding $13,000 not paid back within the tax year. If you fail to charge interest or do not charge interest above a certain rate, the IRS could classify the transaction as a taxable gift or tax you on the interest you would have received from the loan, based on the minimum interest rate, or Applicable Federal Rate (AFR), set by the IRS.

However, as the lender, you may have the option of forgiving a portion of the loan each year up to the amount of the gift tax exclusion. If your child fails to repay the loan, you may be able to write off the default as a short-term capital loss on your taxes.

Due to the complexity of these strategies to minimize gift taxes, it pays to keep informed of changes to the tax laws on a yearly basis. Be sure to consult with one of our qualified tax professionals about your individual circumstances.

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