As the old saying goes, the only constants in life are death and taxes. However, while you can’t avoid paying your share to the government, you may be able to lower your tax burden. Income shifting is a well-known tactic for moving money around so that you don’t have to pay as much in taxes. Today, we’re going to dive into this strategy and see how income shifting might be able to lower your taxes.
The name of this tactic kind of gives it away. To reduce the amount you owe, you simply shift your income to another person. Let’s say that you’re in a relatively high tax bracket (i.e., 35 percent). So, instead of paying all of your income at that rate, you give part of it to a relative in a lower tax bracket (i.e., 10 percent).
By shifting your income, you could be saving a lot of money in the long term. Typically, this practice is done by giving money to either children or elderly relatives, since they will likely have a much lower tax rate.
However, there are some strict rules and regulations regarding income shifting and lowering your taxes, so don’t think it’s a magic solution. Let’s break down how you can do this the right way.
By far, the easiest way to shift your income is to give it to a family member, typically a child. According to the IRS, you can gift up to $15,000 per person in any given year. If you have multiple kids, you can increase the amount of shifted income, thus saving you even more money. Also, your spouse can gift that much as well per child, in case both of you want to take advantage.
That being said, there is a lifetime exclusion limit that currently sits at $11.4 million in 2019. Typically speaking, if you are going to gift more than $15,000 in a single year, you simply have to file gift tax form 709. Fortunately, as long as you haven’t reached the lifetime exclusion, the excess will count towards it.
So, for example, if you give one of your kids $40,000 in a single year, you’ll fill out a 709 form for the $25,000 in excess. That excess will become part of your lifetime exclusion, so you probably won’t have to pay taxes on it at this point. You can continue to do this year after year, with the IRS tracking any overages and adding it to your lifetime total exclusion.
It’s worth noting that you can gift any amount you want to a spouse without having to file a gift tax form. If your spouse is in a lower tax bracket, this may be a viable method of income shifting since there are no limits. However, I would highly encourage you speak with your tax attorney before attempting this strategy.
You can give more than just cold hard cash to your children or relatives. One method of income shifting is to give property or investment assets, such as stocks. If you own the property, you have to pay a higher capital gains tax. If your child owns it, he or she will pay substantially less on any income it produces.
It might seem tempting to give a ton of assets to your children to save on taxes, but Congress has curtailed the amounts that will go untaxed. The Kiddie Tax was enacted to ensure that wealthy individuals don’t avoid paying their share by giving too many assets to their kids. According to this tax, only the first $850 of investment income is tax-free. The next $150 is taxed at 15 percent, and anything over that will be taxed at the parent’s rate.
As you can see, gifting assets has a much more limited scope for income shifting, so we don’t really recommend this strategy.
On the other hand, adult relatives are not subjected to this tax, so feel free to shift assets to a family member in a lower tax bracket (i.e., a grandparent). This way, you don’t have to worry about such strict limitations.
Although giving money to a kid or a relative is by far the easiest method of income shifting, it’s not the only option. If you’re either self-employed or you own a business, you can move money around with a little more flexibility.
In this case, rather than giving your children money as a gift, you pay them for work at the company. Assuming that their annual salary is low enough to keep them within a lower tax bracket, you can still save a lot of money in the long run of course as long as they’re doing the work.
That being said, you have to be careful to avoid triggering an audit. For example, if you pay your children $20,000 in a year for doing nothing, the IRS will view that as fraud. You need to make sure that any earned income is based on actual work done, not “free money” you’re giving to your “employees.”
Some states have more favorable tax burdens than others. If you operate a business in multiple states, you could shift income from one with a higher tax rate to one with a lower rate. Obviously, this method is somewhat complicated and requires a much more extensive business operation, but it’s worth paying attention to if you qualify.
You can also place assets into a non-grantor trust that resides in a lower tax state. You will want to talk to your financial advisor about how to set this up to ensure that you create it properly.
Overall, income shifting is a viable way to reduce your tax burden. If you can save 20 or 25 percent on your income, it can seem highly appealing. However, because it can be a relatively complex process, you need to be sure that you understand the ins and outs first which is why we always recommend speaking with your accountant or tax attorney first.
Also, if you don’t have any children or relatives you can shift income to, it’s not really a viable option. In those cases, you will have to consider alternative methods of reducing your taxable income.
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