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Try A Tax-Free Gift For The Holidays

Shelly K. Schwartz,|Special to CNBC.com
Tuesday, 14 Dec 2010 | 4:31 PM ET

A designer watch for your daughter, who just set her sights on an Ivy League school.

Andersen Ross | Blend Images | Getty Images

A flat screen TV for your son, who can’t find a job.

And a new set of golf clubs for your Dad, who’s shaved six strokes off his game since retiring last fall.

Gifts they’ll want for the upcoming holiday? Sure. But you’d do them all a favor—and your future tax bill to boot—by giving cash or stock instead.

Indeed, taxpayers during the final weeks of the year can significantly reduce the size of their taxable estate by taking advantage of the annual gift tax exclusion—along with two provisions that can that help them maximize the benefit of their goodwill.

TheIRS, of course, allows taxpayers to make annual tax-free gifts of up to $13,000 per recipient. A married couple can jointly gift $26,000 tax-free per year per recipient.

Year-End Investing Tax Tips  -  A CNBC Special Report
Year-End Investing Tax Tips  -  A CNBC Special Report

But a special provision, which is scheduled to sunset this year unless Congress moves to extend it, also permits taxpayers in the 15-percent bracket or below ($34,000 for single filers and $68,000 for joint filers) to avoid paying capital gains.

Until Dec. 31, such taxpayers qualify for the zero-percent rate on capital gains of appreciated assets held for more than a year, including mutual bonds and stocks.

You can incorporate this short-lived tax provision into your gifting strategy by giving an appreciated asset, like stocks, to an adult child, a retired parent or others in the 15-percent or lower tax brackets, which allows them to avoid paying capital gains and you to reduce your taxable estate.

The age of your child, however, is important.

Gifts of investment securities to children under age 24 may be subject to the so-called "Kiddie Tax," in which unearned investment income (interest and dividends) gets taxed at their parent’s marginal rate—regardless of whether they can be claimed as a dependent.

The “Kiddie Tax,” which is meant to discourage taxpayers from shifting assets to their children for the purpose of lowering their own tax bill, generally applies to all of those under age 19, and to dependent full-time students up to age 24.

It kicks in only after your child has more than $1,900 of investment income.Any unearned income below that amount is still taxed at the child's rate.

As a result, says Mark Luscombe, principal tax analyst with CCH in Riverwoods, Il., the strategy of gifting stock to those who qualify for the zero percent capital gains rate “works best if you have older children who are underemployed and still in those lower tax rates, or for elderly parents who are relying solely on Social Security and need a little supplemental income.”

Just be sure the amount you gift, when coupled with any other sources of income including part-time employment, Social Security and retirement plan withdrawals, does not bump the recipient out of the 15-percent bracket.

And be aware, too, that if you gift cash or assets to a college student prior to the start of the junior year, it can impact financial aid, says Bob Adams, a certified financial planner and founder of Armstrong Retirement Planning in Cupertino, Ca., noting that after the start of their junior year the student's assets are not considered for financial aid determination purposes.

Really Thinking Ahead

If you’re feeling flush this year, there is another way to gift large sums to your younger children and still keep the tax collector at bay—particularly if you plan to fund their college education.

As with cash gifts to individuals, gifts to 529 college-savings accounts qualify for the annual gift tax exclusion, meaning you can give $13,000 (or $26,000 for a husband and wife choosing to give a joint gift) tax-free to each of your kids’ 529 plans per year.

But you can also immediately reduce the size of your taxable estate if you opt for the five-year election provision.

As the name implies, the provision allows you to bundle five years worth of cash gifts to a 529 fund into a single year, which amounts to $65,000 for an individual and $130,000 for couples.

For example, if you contribute $25,000 this year and make the election, it will be treated as if you made a $5,000 annual exclusion gift in each of the years between 2010 and 2014.

“Five-twenty-nines are an excellent opportunity for parents, grandparents and others to help fund college expenses because of their tax-free growth, tax-free withdrawal if used for qualified expenses, and some may also benefit from state tax, deductions depending on residency,” says Adams, a certified financial planner and founder of Armstrong Retirement Planning in Cupertino, Ca.

Legally known as “qualified tuition plans,” 529s are tax-advantaged education savings plans for college, and come in two different flavors.

The first is the pre-paid tuition plan, which allows college savers to purchase units or credits at a participating college or university for future tuition, and in some cases, room and board.

College savings plans, meanwhile, are an investment, allowing savers to establish and account for the student or beneficiary and select from several investment options for their contributions, including stock mutual funds, bond mutual funds and money market funds.

Earnings in a 529 plan are not subject to federal tax, and in many cases, state tax, as long as the money is used for eligible college expenses.

Unused 529 money can be transferred without penalty to a sibling or another in a long list of relatives, including cousins, step-relatives, in-laws and even parents.

If 529s aren’t your bag, though, Uncle Sam will also allow you to make unlimited gift payments tax-free at a qualifying domestic or foreign institution for the education of an individual.

To qualify for the educational expense gift exclusion, however, your payments must be made directly to the institution (not the student) and it applies to tuition only, not room and board.

As you hammer out your gift list this holiday season, don’t forget to consider the impact that cash and stock can have on both the size of your estate and the lives of your loved ones.

Another upside? It’s a lot more fun than to leaving it in your will.