Now that lawmakers have made high gift and estate tax exemptions “permanent,” you may feel less pressure to make lifetime gifts to reduce the size of your taxable estate. But regardless of your net worth, gifting continues to offer several tax benefits.
Estate tax insurance
When it comes to estate tax law, permanence isn’t necessarily forever. It simply means that no expiration date has been set. Currently, the combined gift and estate tax exemption is $5.25 million, and under inflation indexing that amount will likely increase in coming years. But that doesn’t mean lawmakers won’t reduce the exemptions down the road.
A regular program of lifetime gifting can provide some insurance against future tax law changes. Nontaxable gifts — such as annual exclusion gifts and direct payments of tuition or medical expenses — are especially effective because they reduce your exposure to estate taxes without using up any of your exemption amount.
The annual exclusion currently allows you to give up to $14,000 ($28,000 for gifts by married couples) tax-free to any number of recipients. So, for example, a couple with five children can give their children a total of $140,000 per year tax-free while preserving their exemptions. And this amount will go up in the future as the annual exclusion is adjusted for inflation.
You can also pay tuition and most medical expenses on behalf of your children or other beneficiaries without using your annual exclusion or lifetime exemption amount. For these gifts to be nontaxable, you must make the expense payments directly to the school or health care provider. Reimbursing the beneficiary won’t work.
Taxable gifts — those that use up some or all of your $5.25 million exemption — can provide some protection against future tax changes. Even if lawmakers reduce the exemption, it’s unlikely that the lower exemption would be applied retroactively to gifts that take advantage of the current exemption amount. There’s one catch, though: If you die within three years after making a gift, its value will be pulled back into your estate, subject to the exemption in effect on the date of death.
Estate tax freeze
If your wealth exceeds the $5.25 million exemption or is likely to grow to exceed the exemption during your lifetime, gifting offers significant tax saving opportunities. For example, if you own assets expected to appreciate in value, giving them to your children or other loved ones — either outright or by way of an irrevocable trust — freezes their value for gift and estate tax purposes. So as long as you survive for at least three years, gifting ensures that all future appreciation on the gifted assets escapes taxation as part of your estate.
Income tax reduction
Even if you’re not concerned about gift and estate taxes, gifting can produce income tax savings. For example, by transferring income-producing assets to your children or other family members in a lower tax bracket, you can reduce your family’s overall tax burden.
Keep in mind, though, that this income-shifting strategy won’t work if your children are young enough to trigger the “kiddie tax.” That tax — which applies your marginal rate to most of a dependent child’s unearned income — applies to children age 18 or younger (23 or younger for full-time students).
Also, if you give away highly appreciated assets, the recipients will take over your tax basis. This can trigger a substantial capital gains tax bill should they sell the assets. For such assets, consider whether there is a tax advantage of waiting until death to make the transfer, when your beneficiary will get a step-up in basis.
Have a plan
Gifts continue to offer significant benefits. Your tax advisor can help you design a lifetime gifting plan that reduces your exposure to gift and estate taxes and perhaps saves income taxes as well.