When giving assets to a beneficiary, whether cash or property, the government may want to know about it and might even want to collect what the Internal Revenue Service (IRS) refers to as a gift tax.
Fortunately, a large portion of some gifts or estate assets are excluded from taxation and there are numerous ways to give assets tax-free.
Some exclusions are:
– Using the annual gift tax exclusion of $15,000
– Using the lifetime gift and estate tax exemption
– Making direct payments to medical and educational providers on behalf of a loved one
In general, aside from reductions in the taxable estate, there are other perks to giving assets to family members or loved ones while still living. Giving today offers immediate assistance to all beneficiaries while providing the extra enjoyment of witnessing the joy of seeing how the gifts improve their lives.
The gift tax exclusion
Current rules allow funds to be given to any number of people up to $15,000 each in a single year without incurring a taxable gift ($30,000 for if married with a spouse’s gift). The recipient owes no taxes when they receive the gift and does not have to report the gift unless it comes from a foreign source.
If the amount given to any person during the same year exceeds $15,000, the grantor (person making the gift) must file a gift tax return (IRS Form 709). Once the gift exceeds the annual gift tax exclusion, taxes begin to chip away at the lifetime gift and estate tax exemption as discussed next.
The gift and estate tax exemption
The passage of the Tax Cuts and Jobs Act (TCJA) increased the gift and estate tax exemption significantly. Prior to 2018, the exemption amount was $5.49 million. The TCJA increased that amount to $11.7 million for estates 2018 forward. The Federal gift and estate tax rate is 40%.
The $11.7 million exemption applies to gifts and estate taxes combined. Whatever exemption used for gifting reduces the amount eligible for the estate tax. The IRS refers to this as a “unified credit.” Each grantor has a separate lifetime exemption that can be used before any out-of-pocket gift or estate tax is due. In addition, a married couple can combine their exemptions to get a total exemption of $23.4 million with a proper estate plan.
There is one big caveat to be aware of. The $11.7 million exception is temporary and only applies to tax years up to 2025, at which time it will revert to the $5.49 million exemption (adjusted for inflation). It might be a smart move to take advantage of the new exemption before it disappears after 2025. Although, Congress may decide to make these changes permanent after 2025 the exemption expires.
Lock in the higher exemption now
For most people, the gift and estate tax exemption allows for the tax-free transfer of wealth from one generation to the next. There are several other strategies that could be advantageous for those who have acquired enough wealth to surpass the gift and estate tax exemption.
Many individuals find it best to transfer their wealth to their loved ones now, rather than willing it to them later. There are two advantages to giving assets today. First is the chance to see them enjoy the benefits. Second, any increase in the value of the gifted assets could increase in value for beneficiaries, rather than the taxable estate. This would shift the increase in the value of the estate to the next generation and avoid estate tax.
For example: If an individual gives his or her entire estate of $11.7 million to their children today, those assets could increase in value over time. At a growth rate of 5% per year for 10 years, that $11.7 million gift could end up being worth over $19 million, and the heirs will have received the entire amount free from gift or estate taxes. Weigh that against holding those same assets until passing away 10 years later. That increase in value would be taxed at 40%. Additionally, should the gift and estate tax exemption revert to the lower $5.49 million amount (for dates after 2025), the result would be an even larger estate tax amount upon passing.
Ensuring gifts are managed responsibly
One concern many people have when it comes to giving assets away early is that sometimes the person receiving the gift may not be ready to handle the responsibility of managing such a large amount of money or assets. A good example of this is a large amount of money gifted to a young child or teenager. One option for gifting those assets and ensure they are protected from misuse would be to give them to an irrevocable trust and have the child or teenager listed as the beneficiary.
This method allows rules to be set for the trust along with instructions on how the assets will be invested and distributed. For example, create a trust that stipulates the beneficiary can only have access to the income generated once the beneficiary graduates from college. It is also possible to specify when the trust would distribute the assets and at what age, circumstances, etc. There are numerous options when it comes to structuring a trust with each state having its own rules.
Other ways to give tax-free
Make unlimited payments directly to medical providers or educational institutions on behalf of others without incurring a taxable gift or affecting the $15,000 gift exclusion. This method is a great way to assist someone with large medical bills or provide for a family member’s education. For example, it is possible to pay $50,000 tuition for a grandchild’s medical degree by making payments directly to the university, while also gifting an additional $15,000 per year tax-free.
Tax effect to the recipient of gifts
One thing to remember about gifting assets is that the cost basis in the assets will transfer over to the recipient. In other words, if a gifted asset appreciates in value significantly prior to the gift, the recipient could incur a substantial taxable gain when selling that asset. On the other hand, highly appreciated assets that are received as part of an estate on death get a “step up” in basis to the value at death, which means a taxable gain could be avoided if the asset is sold after death. It is important to carefully select what assets can be gifted to minimize the impact of taxes. In general, cash and assets with little appreciation are better for gifts, while highly appreciated assets are better transferred as part of the estate.
Lifetime gifting can be a great strategy if enough is left over for personal living expenses. For the gift to count, it must be a complete and irrevocable transfer. This article focuses on the federal tax implications for gifting and estates; however, there could be state tax consequences for gifts and estate. Take the time to meet with a tax and estate planning professional to ensure all gift and estate plans are well thought out and properly implemented.
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.