The Estate Tax and Lifetime Gifting
January 15, 2014
- A great strategy for reducing estate taxes is to spread gifts throughout your lifetime. Just be sure to leave yourself enough to live on.
- Good options for minimizing taxes include giving away up to $14,000 per recipient per year gift-tax free, and making payments directly to medical and educational providers on behalf of loved ones.
As a general rule, it's better to give away money during your lifetime than to leave it to your heirs after you pass away. There are numerous ways to give money to your loved ones gift-tax free while you're alive—and even if your gift is taxable, at least the recipient can enjoy the gift's full value while you pay the taxes on it. In contrast, if your estate is subject to the estate tax, those taxes will come directly out of what your loved ones would otherwise inherit.
Picture four quarters on the table in front of you. If you die with all four quarters and you're in a 50% estate tax bracket (the current top rate is 40%, so 50% is not unimaginable), your heirs are left with two quarters and the federal government gets the other two.1 That's the estate tax in action.
Now imagine a different scenario. You start with four quarters and move two quarters aside, representing a lifetime gift to your loved ones. Take one quarter and move it to the other side of the table as the gift tax you would owe.1 Your beneficiaries have as much as they did in the first scenario, and you've still got a quarter left!
Gifting provides a couple of added bonuses. For one, any future appreciation on the gift is in the hands of the beneficiary and outside your estate. Plus, you get to participate in the enjoyment of the gift while you're still around.
Below are the rate and exemption levels for gift and estate taxes in 2014:
|Estate tax||Gift tax|
|Top rate||Exemption||Top rate||Exemption|
|40%||$5,340,000 per person2||40%||$5,340,000 per person2|
How the gift tax works
Currently, you can give up to $14,000 each to any number of persons in a single year without incurring a taxable gift ($28,000 for spouses "splitting" gifts). The lucky recipient of the gift typically owes no taxes and doesn't have to report the gift unless it came from a foreign source. You can also make unlimited payments directly to medical providers or educational institutions on behalf of others for qualified expenses without incurring a taxable gift.
If your gift exceeds $14,000 to any person during the course of the year, you have to report the taxable gift on a Gift Tax Return (IRS Form 709). Spouses splitting gifts must always file Form 709, even when no taxable gift is incurred.
For taxable gifts, each donor has an aggregate lifetime exemption before any out-of-pocket gift tax is due. In other words, under current law you can give away up to $5.34 million2 during your lifetime—over and above the annual $14,000 exclusion and any payments you make directly to educational or medical providers on behalf of another—and still avoid gift tax.
There's one big caveat here. Whatever exemption you use for gifting will reduce the amount you can use for the estate tax—the $5.34 million2 exemption applies to gift and estate taxes combined. (This is what the IRS refers to as a "unified credit.") That said, surviving spouses may claim any unused exemption from the deceased spouse.
Example 1: You're unmarried and give away $3 million (over the $14,000 per person annual exclusion) during your lifetime. After you die, $2.34 million of your estate is still exempted from the estate tax.2
Example 2: Your spouse gives away $4 million and you give away $1 million (over the $14,000 per person annual exclusion) during your lifetimes. If one of you passes away, the surviving spouse will have a $5.68 million estate tax exemption ($1.34 million of unused exemption from your spouse plus $4.34 million of your unused exemption).2
Lifetime gifting and estate planning
Typically, it's a great strategy to take advantage of the annual $14,000 exclusion and make payments directly to medical or educational providers on behalf of loved ones to preserve your lifetime exemption.
However, if you have a large estate, your strategy might also include making taxable lifetime gifts utilizing the lifetime exemption—or more if your net worth is very high.
Most advanced wealth-transfer strategies minimize gift taxes by taking advantage of the annual exclusion, the lifetime exemption and valuation discounts available under the law (a valuation discount means the gift is worth less than its apparent value for gift tax purposes).
Finally, a couple of caveats:
- Lifetime gifting can be a great strategy, as long as you leave yourself enough to live on. For the gift to count, it has to be irrevocable, 'so be sure to plan carefully with the help of a professional.
- If the estate tax is ever repealed, as it was for the 2010 tax year, you may regret having paid gift tax now in an effort to minimize your estate tax. You have to do the best you can, based on what you know now, within the context of your goals.
1. This hypothetical scenario assumes you have already exhausted your gift-tax exemption during your lifetime, leaving you subject to full taxation on the remaining gift or estate.
2. Estate and gift tax exemptions are adjusted annually for inflation.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The strategies mentioned here may not be suitable for everyone. Each investor needs to review an estate strategy for his or her own particular situation before making any related decisions.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.