The Estate Tax and Lifetime Gifting

February 14, 2013

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Based on recently enacted federal legislation, we finally have some clarity with respect to estate and gift-tax law. For now, here are the rate and exemption levels:

Lifetime gifting

Lifetime gifts are generally better than testamentary gifts when transferring wealth.

Think of it this way: 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, your heirs are left with two quarters and the federal government gets the other two. Instead, move two quarters aside representing a lifetime gift to your loved ones. Now, take 50% of your remaining two quarters, or one quarter, and move it to the other side of the table as the gift tax you would owe (assuming you've already exhausted your lifetime exemption). Look—you've still got a quarter left!

Gifting provides a couple of added bonuses, as well. 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 alive, instead of after it's too late.

How gifting 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 gift tax or income tax, and doesn't even 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 you make a gift of more than $14,000 to any one 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 also 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 $5.25 million (annually adjusted for inflation) during your lifetime—over and above the annual 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: a unified credit applies to both the gift tax and estate tax, so the total amount of credit used against your gift tax during your lifetime reduces the credit available to use against your estate tax. However, surviving spouses may additionally claim any unused exemption from the deceased spouse.

Lifetime gifting and estate planning

Typically, it's a great strategy to take advantage of the annual $14,000 exclusion, make payments directly to medical and educational providers on behalf of loved ones and preserve your lifetime exemption.

However, for those with large estates, it often makes sense to also make taxable lifetime gifts utilizing the lifetime exemption—or even beyond 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. You don't want to give until it hurts, so be sure to plan carefully with the help of a professional.
• If the estate tax is repealed again in the future, you may regret having paid gift tax now in an effort to minimize your estate tax. Again, you have to do the best you can based on what you know now, within the context of your goals.

1. Estate and gift tax exemptions are stated in 2013 dollars and adjusted annually for inflation.