The process of estate planning generally involves developing a plan to pass family wealth from an older generation to a younger generation while minimizing or eliminating estate taxes. Transferring wealth to the next generation can be accomplished as part of an estate plan that takes effect at death and can be advanced by making gifts during lifetime. If you are fortunate enough to be in a position to make lifetime gifts, you will want to ensure that your family members are well equipped to responsibly handle what they receive. This article gives an overview of lifetime giving and the important, related topic of next generation financial literacy.
The current tax laws allow a person to make annual gifts of up to $15,000 to as many individuals as he or she wishes without such transfers being treated as gifts for gift tax purposes. The recipient of the gift does not need to be a family member. The amount of the so called “annual exclusion” is inflation-adjusted and increases periodically by $1,000 increments. There are several benefits of lifetime giving, some of them practical, and some personal. On the practical side, lifetime giving can provide tax benefits. A well-planned program of lifetime giving can effectively reduce the size of your estate that may eventually be subject to estate tax by not only removing the assets from your estate, but also removing any future appreciation on those assets if you were to hold them until death. On the personal side, giving during your life may provide funds to the person receiving the gift when they are needed now rather than in the future, and allows you to see the person benefit from the gift.
Lifetime giving to younger family members, such as grandchildren, can also present the perfect opportunity to start a conversation with the next generation about financial literacy. Financial literacy is an understanding of how to effectively manage your personal finances for a sound financial future. While financial literacy encompasses many areas, this note will focus on two of the fundamentals, budgeting and saving.
Poor spending habits are one of the greatest risks to a person’s financial security, which is why it is crucial to gain control of spending by creating a budget. A budget will identify one’s earning and spending habits and help determine and achieve savings goals. To get started with a budget, one needs to identify sources and uses of cash. The sources of cash might include salary, social security or portfolio income. The uses of cash include fixed expenses (mortgage payments, utilities, insurance, property taxes, healthcare, etc.) plus discretionary and lifestyle expenses.
In order to keep uses of cash in line with sources of cash, one needs to consider his or her financial priorities. It is important to find a financial balance among those priorities and reflect that in one’s spending. The standard budget guideline is the 50/20/30 approach, allocating 50% of income to essential living expenses, 20% to savings (15% to long term goals and 5% to short term goals) and the remaining 30% to discretionary spending such as dining out, travel and entertainment. This standard may need to be customized depending on one’s lifetime goals, earnings and other circumstances. Once a basic budget is in place, it can be used to create a plan to achieve one’s goals, including determining how much to save for retirement based on projected income and spending habits, estimated social security or pension benefits, and the age at which one can comfortably retire.
Another critical component of financial literacy is saving. Saving is the best way to prepare for lifetime financial goals such as retirement, buying a home, and sending children to college. And although retirement may be years away for some, time is a valuable asset allowing investment returns to compound. The earlier one starts to save, the better off he or she will be, as illustrated by the chart below.
For example, a 30 year old who begins saving $10,000/year, generating a 6% annual return, with plans to retire at age 65, will accumulate approximately $1.2MM at retirement. Comparatively if he does not begin saving until age 40, he must double the savings rate to $20,000/year to attain $1.2MM by age 65. A 50 year old must save $47,000/year to achieve the same results. This illustrates the importance of starting to save early in life.
Engaging in lifetime giving to younger family members can be an excellent way to open a conversation with the next generation about financial literacy. Introducing the fundamental concepts of budgeting and saving early on can help the next generation develop into financially secure and responsible adults who are not only well equipped to manage their own assets, but also assets they may inherit, proving that financial literacy is itself a valuable gift.