- Lifetime Exclusion
- Annual Exclusion
- Medical Exception
- Education Exception
- Gifting Techniques
If you are fortunate enough to have an estate large enough to be subject to the estate tax upon your death, you might be considering ways to give away some of your wealth to your family and loved ones now, thereby reducing the estate tax when you pass on. This tax strategy may be more important this year than it has been in the last few years, because legislation being considered by Congress would reduce the lifetime gift and estate tax exclusion by about half while retaining the annual gifting exclusion.
Frequently, taxpayers think that gifts of cash, securities or other assets they give to other individuals are tax-deductible; in turn, the gift recipient sometimes thinks income tax must be paid on the gift received. Nothing can be further from the truth. To fully understand the ramifications of gifting, one needs to realize that gift tax laws are interrelated with estate tax laws, and Uncle Sam does not want you giving away your wealth before you pass away to avoid the estate tax. For individuals who die in 2021, federal law allows $11.7 million (lifetime estate tax exclusion) to pass to your heirs estate-tax free, and any excess amount is subject to an estate tax as high as 40%. If passed, the legislation referenced above would lower the exclusion to $5 million, adjusted for inflation.
Amounts you gift in excess of the annual gift tax exclusion amount prior to your death reduce the lifetime estate tax exclusion and will therefore subject more of your estate to taxation.
Example: Jeff gives his daughter $100,000 in 2021. This is $85,000 more than the $15,000 annual gift tax exclusion. Jeff will need to file a gift tax return reporting the gift. The $85,000 excess (and any additional excess amounts from other years) will reduce his estate tax exclusion, whatever amount it may be, in the year he dies.
The law does provide exceptions where gifts can be made without reducing the lifetime exclusion, including the following:
- Annual gift exclusion available each year to any number of individuals. The amount is periodically adjusted for inflation, and the amount for 2021 is $15,000 (projected to be $16,000 for 2022). The recipient does not have to be a relative or an audult. Unlimited amounts can be gifted to a U.S. citizen’s spouse. Gifts can be cash or the transfer of real or personal property.
- Directly pay medical expenses. This applies to amounts paid by one individual on behalf of another individual directly to a medical care provider as payment for that medical care. Payments for medical insurance qualify for this exclusion.
- Directly pay education expenses. This applies to amounts paid by one individual on behalf of another individual directly to a qualifying educational organization as tuition for that other individual. The tuition can be for any level of schooling—elementary, secondary or post-secondary. Costs of room and board, books, supplies or other similar expenses aren’t eligible as direct payments, nor are contributions to qualified tuition programs (also known as Sec. 529 plans), which have their own gifting rules not covered in this article.
If the gift giver is married and both spouses agree, gifts to recipients made during a calendar year can be treated as split between the husband and wife, even if only one of them made the cash or property gift. Thus, by using this technique, a married couple can give $30,000 in 2021 to each recipient under the annual limitation discussed previously.
High-Wealth Individuals – If you are a high-wealth individual who would like to pass on as much to your heirs as possible while living, without reducing the lifetime exemption, you could directly pay your future heirs’ medical expenses and education expenses in addition to annual gifts of cash or property of up to $15,000 (2021). You may want to do this even if you are not a high-net-worth individual, to avoid having to file a gift tax return.
Medical Expenses – Except in rare circumstances, you cannot deduct the medical expenses you pay for another person, and they cannot deduct the expenses either, since they did not pay the expenses. Thus, consider carefully whether to make the gift directly to the individual, subject to the annual limit—which would allow the recipient of your generosity to pay the medical expenses and claim the medical deduction on their tax return—or whether you pay the medical expenses directly. If the medical expenses you want to pay are greater than the annual limit, then you could always gift $15,000 (2021) to the individual and pay the balance directly to the care provider(s) to avoid reducing your lifetime exclusion. Under rare circumstances, the recipient who will benefit from your gifts may qualify as your medical dependent, under which circumstance you would be able to deduct the medical expenses if they were paid directly to the doctor, hospital or other provider.
Education Expenses – When you pay the qualified post-secondary education tuition for another individual, it does not mean (as is usually the case for medical expenses) that someone cannot benefit taxwise. Tax law says that whoever claims the student as a dependent is entitled to the American Opportunity Credit or Lifetime Learning Credit for higher education expenses if they otherwise qualify.
Gifts of Appreciated Property – Consider replacing your cash gifts with gifts of appreciated property, such as stock for which you have a “paper gain.” When you gift an appreciated asset, the potential gain on the asset transfers to the recipient. This works for individuals, except for children who are subject to the kiddie tax, which requires the child’s income to be taxed at the parent’s tax rate if it is higher than the child’s rate. It also works great for contributions to charitable organizations. Although not subject to the gift tax rules, not only does an appreciated asset gifted to a charity get you out of reporting any gain from the appreciation, but you also get a charitable tax deduction equal to the fair market value (FMV) of the asset. The deduction for these gifts is generally limited to 30% of your adjusted gross income (AGI), but the excess carries over for up to five years of future returns.
Keep in mind that to utilize this year’s annual exclusion amount, the gift must be transferred to your designated recipient by December 31, and exclusion amounts not used this year do not carry over to next year.