Family Wealth Series: Let’s Talk About Tax Strategies

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Speaking to your grown children about important tax strategies and considerations could help them make decisions now that will impact their financial future.

Taxes are a part of life. But sharing effective tax strategies with adult children could improve their financial standing for years to come.

Here, wealth planners with Wells Fargo Private Bank share six important messages to convey when you talk to your adult children about taxes.

Give your adult children details on what funds to withhold from their paychecks

Start with the basics: The W-4 form, which is changing considerably this year, determines how much federal income tax will be taken out of each paycheck. The IRS online tax withholding estimator is a great resource for reviewing tax withholding amounts, says Cody Tresselt-Warren, a Senior Wealth Planner at Wells Fargo Private Bank.

Many employees have too much withheld, which means they get a huge tax refund each year. This may sound nice, but it means they basically gave the IRS an interest-free loan for a year.

If your child also has investment assets, calculating the correct withholding amount becomes trickier. In those cases, Tresselt-Warren suggests meeting with a wealth planner or tax preparer for guidance.

Encourage them to sign up for a workplace retirement plan

Your adult child or grandchild should contribute as much as they can to their workplace retirement plan—and at the very least, they should contribute the amount that the company matches, says Derek Dockendorf, a Senior Wealth Planner at Wells Fargo Private Bank. Those contributions could also reduce their tax liability.

“Contributions to a traditional 401(k) are made on a pre-tax basis, meaning the incomes are deferred until a future date,” according to Dockendorf. “The contributions also have the potential to grow tax-deferred as well, again delaying the income tax liability to a future date. Encourage them to participate in the company plan by reminding them that, if they contribute enough to get the company match, that company match is essentially ‘free’ money being added to their retirement account.”

Help your child understand the difference between a traditional 401(k) and a traditional IRA–which may provide tax savings today for contributions–and a Roth 401(k) and Roth IRA—which offer tax savings down the road in the form of tax-free qualified withdrawals in retirement. A wealth planner could help them determine which type of account could offer them the most benefits, Dockendorf says. (Need a refresher on the differences yourself? Learn more about traditional IRAs versus Roth IRAs).

Explain the potential benefits of a health savings account (HSA)

If your child has a high-deductible health plan and access to a health savings account (HSA), explain these benefits:

  1. Contributions reduce taxable income.
  2. Growth in the account is tax-free.
  3. Withdrawals are tax-free if the money is used for qualified medical expenses.

“For healthy young adults who don’t have a lot of medical expenses, HSAs can be a powerful tax savings strategy, both short term and long term,” Tresselt-Warren says.

A flexible spending account (FSA) is another way to save on taxes because contributions reduce your taxable income when spent on qualifying health expenses, such as doctor copays or prescriptions. But make sure your child understands that FSAs are “use it or lose it,” which means they can’t keep money that’s left in the account at the end of the year. Underscore the importance of estimating as accurately as possible their medical spending for the year.

Discuss tax moves related to income beyond, or instead of, income from an employer

If your child is being paid as an independent contractor (and receiving 1099s) or running a business on the side of their nine-to-five job, explain that they should make quarterly estimated tax payments on that income. Remind your child that they could trim their tax bill by tracking their business expenses. For example, they could deduct business mileage on their car, dues and subscriptions to business-related organizations, related tools and equipment, and even the portion of their home used for the business.

Spell out the tax implications of a trust fund or inheritance

If your children will inherit an investment portfolio, make sure they understand those assets could be generating interest and dividend income that increases their tax liability, even if there’s no cash flow from the portfolio. “If the interest and dividends that are earned during a given year are being reinvested back into the portfolio, instead of consumed as part of annual spending,” Dockendorf says, “those earnings are still subject to income tax, even though the child didn’t receive the earnings in the form of cash in their pocket.”

Another common scenario: Trust fund beneficiaries who don’t always realize there could be tax implications when they make a withdrawal. (Learn more about what trust beneficiaries should know.) “Make sure your child has money set aside to cover any tax liability,” Dockendorf says. “I’ve seen a lot of cases where as soon as they get the money, it’s spent. Then when the taxes come due, they ask Mom and Dad to write a check.”

Describe strategies for charitable contributions

If your child is making significant charitable donations, talk to them about the advantages of “bunching,” a tax strategy of lumping two or more years of charitable donations into one year so they exceed the standard tax deduction and can itemize. “They can put those donations into a donor advised fund and get an immediate tax deduction, and then the money can be distributed to the charities of their choice over the next three years,” Tresselt-Warren says.

Wells Fargo & Company and its affiliates do not provide legal or tax advice. Wells Fargo Advisors is not a legal or tax advisor. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.