Gifting financial or personal assets in the present day offers immediate resources to a person’s beneficiaries and provides the extra enjoyment of watching the gifts enrich their lives. While it can be personally rewarding to bask in their delight, there are added tax benefits, such as reductions in the taxable estate as a whole.
When giving assets of cash or property to a beneficiary, whether it be a relative or friend, the government may want to know about it and perhaps collect what the IRS refers to as a gift tax. Fortunately, a large portion of some gifts or estate is excluded from taxation such as:
- Using the current annual gift tax exclusion
- Using the current lifetime gift and estate tax exemption
- Making direct payments to medical and educational providers on behalf of a loved one.
Current gift tax exclusion rules allow funds to be given to any number of people up to $16,000 each in a single year without incurring a taxable gift ($32,000 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.
The gift and estate tax exemption amount is $12.06 million for 2022, up from $11.7 million for 2021. For most people, the gift and estate tax exemption allows for the tax-free transfer of wealth from one generation to the next. The $12.06 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 $24.12 million with a proper estate plan.
Many individuals prefer 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 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.
The $12.06 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). Although Congress may decide to make these changes permanent after 2025 the exemption expires, it might be a smart move to take advantage of the increased exemption in the event it disappears after 2025. In addition, under the Build Back Better Plan being considered by Congress, changes to the exemption could occur sooner than later; so contemplate gifting before this might be enacted.
By way of example, if an individual gives their entire estate of $12.06 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 $12.06 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 the Federal gift and estate tax rate of 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.
Another way to give tax-free is to make unlimited payments directly to medical providers or educational institutions on behalf of others without incurring a taxable gift or affecting the $16,000 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 $16,000 per year tax-free.
There are important tax effects and considerations for both the giver and recipient to understand.
First, if the amount given to any person during the same year exceeds $16,000, 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.
When gifting assets, it is also important to remember 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.
One concern many people have when it comes to giving assets away early is 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.
In summary, 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. While this article focuses on the federal tax implications for gifting and estates, there could also 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.
Author, Jeff Spiegel, CPA
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.