The Estate Tax and Lifetime Gifting

May 18, 2023 Hayden Adams
If you have a large estate, consider gifting during your lifetime as a strategy to help reduce estate taxes.

When you give assets to someone—whether cash, stocks, or a car—the government may want to know about it and may even want to collect some taxes. Fortunately, a large portion of your gifts or estate is excluded from taxation, and there are numerous ways to give assets tax-free, including these:

  • Using the annual gift tax exclusion
  • Using the lifetime gift and estate tax exemption
  • Making direct payments to medical and educational providers on behalf of a loved one

In general, it's better to give assets to your loved ones while you're still alive rather than after you pass away. If you have the means, giving today allows your loved ones to benefit from your gifts right away and gives you the enjoyment of seeing your gifts improve their lives. In addition, those gifts can grow in value in their hands, rather than yours, which helps reduce your taxable estate.

How the gift tax "exclusion" works

Currently, you can give any number of people up to $17,000 each in a single year without incurring a taxable gift ($34,000 for spouses "splitting" gifts)—up from $16,000 for 2022. The recipient typically owes no taxes and doesn't have to report the gift unless it comes from a foreign source.

However, if your gift exceeds $17,000 to any person during the year, you have to report it on a gift tax return (IRS Form 709). Spouses splitting gifts must always file Form 709, even when no taxable gift is incurred. Once you give more than the annual gift tax exclusion, you begin to eat into your lifetime gift and estate tax exemption.


How the gift and estate tax "exemption" works

With the passage of the Tax Cuts and Jobs Act (TCJA), the gift and estate tax exemption has increased significantly. The chart below shows the current tax rate and exemption levels for the gift and estate tax:

How the gift and estate tax "exemption" works

With the passage of the Tax Cuts and Jobs Act (TCJA), the gift and estate tax exemption has increased significantly. The chart below shows the current tax rate and exemption levels for the gift and estate tax:

Highest tax rate 
(for gifts or estates over the exemption amount) 
Gift and estate exemption 
(2017 and prior years) 
Gift and estate exemption 
(2023, expires 12/31/2025) 
40% $5.49 million* $12.92 million*

The $12.92 million exemption applies to gifts and estate taxes combined—any portion of the exemption you use for gifting will reduce the amount you can use for the estate tax. The IRS refers to this as a "unified credit." Each donor (the person making the gift) has a separate lifetime exemption that can be used before any out-of-pocket gift tax is due. In addition, a couple can combine their exemptions to get a total exemption of $25.84 million.

There's one big caveat to be aware of: the $12.92 million exception is temporary and only applies to tax years up to 2025. Unless Congress makes these changes permanent, after 2025 the exemption will revert to the $5.49 million exemption (adjusted for inflation). So here is the big question: if this new exemption disappears after 2025, how do you take advantage of it before then?

How to lock in the exemption

For most people, the gift and estate tax exemption allows for the tax-free transfer of wealth from one generation to the next. For those who have acquired enough wealth to surpass the gift and estate tax exemption, there are several strategies that could lock in the $12.92 million exemption.

The simplest way is to gift your assets to your loved ones now, rather than waiting until you pass away. For example, if you were able to give the entire $12.92 million to your children today, that money could grow over time. At a hypothetical investment growth rate of 5% per year for 10 years, that $12.92 million gift could end up being worth over $21.04 million, and your loved ones will have received the entire amount free from gift or estate taxes.

On the other hand, if you held onto those assets and you passed away in 10 years, a large portion of the $21.04 million would be taxed at 40%. Additionally, in 10 years the gift and estate tax exemption will have likely reverted to the lower $5.49 million amount (for dates after 2025). That could result in your estate having to pay over $4.89 million in federal taxes, leaving your heirs with about $16.15 million in after-tax assets rather than $21.04 million had you made the gift sooner.1

Ensuring your gifts are used and managed properly

One concern many people have about giving assets away early is that sometimes the person receiving the gift may not be ready to handle the responsibility of managing such a large amount of money. A good example is a large amount of money gifted to a young child or teenager. One way to give those assets, but ensure they are protected from misuse, would be to give them to an irrevocable trust and make the child or teenager the beneficiary. 

This method allows you to set the rules of the trust and determine how the assets will be invested and distributed. For instance, you could create a trust that stipulates the beneficiary can only have access to the income generated by the assets—or you could set specific rules, such as requiring the beneficiary to graduate from college before having access to the funds in the trust.

There are numerous options when it comes to structuring a trust, and each state has its own rules. If you're interested in learning more about the various options available, take the time to meet with an attorney or tax professional in your area.

Other ways to give tax-free

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 or affecting your $17,000 gift exclusion. This method is a great way to help a loved one with large medical bills from an illness or to help pay for a family member's education.

For example, say you wanted to pay your granddaughter's $50,000 tuition for her medical degree. You could pay the university directly for her tuition and still give her an additional $17,000 tax-free. This strategy reduces your taxable estate and helps preserve your lifetime gift and estate exemption.

How to minimize taxes for recipients

One thing to remember about the assets you gift is that your cost basis will transfer over to the recipient. So, if that asset has appreciated in value significantly prior to the gift, the recipient could incur a substantial taxable gain when selling that asset. Highly appreciated assets that are received as part of an estate, on the other hand, generally get a "step up" in basis (resetting the cost basis at the current market rate), which means a taxable gain could be avoided if the asset is sold soon after being received.

In a nutshell, you need to carefully select what assets you gift to minimize the impact of taxes. In general, cash and assets with little appreciation are better for gifts, while highly appreciated assets are better to transfer as part of your estate.

Finally, a few caveats

  • Lifetime gifting can be a great strategy, as long as you leave yourself enough to live on.
  • For the gift to count, it must be a complete and irrevocable transfer.
  • This article only focuses on the federal tax implications for gifting and estates. Depending on where you live, there could be state tax consequences for your gifts and estate.

Take the time to meet with a tax and estate planning professional to ensure your gift and estate plans are well thought out and properly implemented. As with any tax planning strategy, there is always the possibility that Congress could change the laws related to the gift and estate tax exemption. You'll want to review your gift and estate strategy each year to be sure that your plans are still relevant based on your financial situation or changes in tax laws.

1Calculations assume the prior $5.49 million exception will be adjusted for inflation, estimated to be 3% per year, resulting in an exemption of $8.8 million in 10 years from 2023. The taxable estate would be $12.24 million ($21.04 million minus $8.8 million), resulting in $4.89 million in taxes ($12.24 million times the 40% tax rate).

Learn about tax-smart strategies. 

Tax-Efficient Investing: Why Is It Important?

Making tax-efficiency part of your investing strategy can help lower your tax bill.

When to Consider Munis From Outside Your Home State

Although investing in in-state municipal bonds may have tax advantages, there can be good reasons to buy out-of-state munis.

Is It Better to Give Stock or Cash to a Charity?

Donating stock (as opposed to cash) to a nonprofit can benefit both you and the charity.

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.

Investing involves risk including loss of principal.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market 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.