Gift Tax 101: Should the Annual Exclusion Amount Limit Your Generosity?

Most Americans are (at least somewhat) familiar with income taxes, since they must file income tax returns each year.  Sales tax is straightforward— i.e. the pesky fact of life that, from an early age, compelled you to fork over $1.10 for a $1 candy bar.  Gift and estate taxes, however, remain shrouded in mystery for many of us, leading to some misunderstandings about how much we can give to our loved ones tax-free during our lifetimes or after we pass away.  We discuss the gift tax rules here, focusing particularly on how most Americans can avoid ever paying it, even if they gift significant assets during their lifetimes.

Annual Gift Tax Exclusion.  We may want to give our kids or other loved ones the sun, the moon, and the stars, but once they are no longer our dependents for tax purposes, we cannot give them more than $15,000 per year (in 2019) without potential gift tax consequences.  This limit does not apply to charitable giving or to gifts between spouses (as long as both are U.S. citizens), and it does increase over time (e.g., the limit was $13k from 2009 to 2012, $14k from 2013 to 2017).

• Nuances and Exceptions to the Rule.  If you are able and interested in giving more than $15k in a particular year, there are several facets of the gift tax rule that may help.  First, the $15k limit applies to gifting from one individual to another individual.  Therefore, if you are married and wish to give to an adult child, you and your spouse can jointly give $30k.  If your adult child is married, together you and your spouse can give a total of $60k to your child and his/her spouse.  Second, if your child or other loved one is in need of money because of high education or medical costs, you can give an unlimited amount on their behalf if you pay it directly to the relevant educational institution (for tuition only), medical service, or health insurance provider.

Lifetime Gift Tax Exclusion.  If none of the exclusions above apply, will you pay an arm and a leg in gift taxes to the IRS?  No!  The final and most significant nuance to the federal gift tax system is that every individual in the U.S. has a lifetime gift tax exclusion of $11.4 million (indexed for inflation).  If you give more than the annual exclusion amount, you simply have to file a Gift Tax Return (IRS Form 709), and the amount exceeding the annual limit will be counted against your lifetime gift tax exclusion.  For example, if you give $115k to a close friend in 2019 and file Form 709 reporting the gift, your lifetime gift tax exclusion will decrease by $100,000 and will now be $11.3 million.

• Caution on Using the Lifetime Exclusion.  If giving above the annual exclusion amount is as simple as filling out a 5-page form, why should anyone hesitate to do so?  First, it is not a simple task to fill out Form 709 correctly, to calculate the remaining lifetime exclusion and track the inflation adjustment on that amount going forward.  Unless an individual has expertise in this area, he or she should engage the help of a financial adviser and CPA, which might be a deterrent if one is not already working with these types of professionals.  Second, $11.4 million is not just the lifetime gift tax exclusion amount; it is also the estate tax exclusion amount (for 2019).  In other words, when you die, you can pass $11.4 million in assets to your heirs without triggering the estate tax.  However, if you use up a portion of the lifetime gift tax exclusion, you also must subtract that amount from your estate tax exclusion.  Thus, if your assets are close to that $11.4 million limit now (and may continue to grow over your lifetime), you may want to use the annual gift tax exclusions mentioned above instead of using any of your lifetime gift tax exclusion, since that may result in triggering the estate tax for your heirs when you pass away.  If you do end up paying the gift tax—or if your heirs pay estate tax—you will face tax rates that range from 18 percent to 40 percent, depending on the amount of taxable transfers.

When working with clients who clearly have more assets than they will need for their lifetimes, we regularly suggest lifetime giving to loved ones and/or to charity.  That way, they can experience the joy of sharing their wealth and making a difference in others’ lives, rather than just having their assets transfer to their heirs after they pass away.  Given the gift tax exemptions discussed above, the vast majority of Americans should have no concern about tax consequences if they want to gift assets to their loved ones during their lifetimes.  With some strategic planning, even most wealthy Americans can avoid the gift tax and the likelihood of estate tax for their heirs as well.

Note:  Our focus in this article is on federal tax law.  Currently, Connecticut is the only state that imposes its own gift tax, which applies to amounts that exceed the annual gift tax exclusion discussed above.  Many states also have their own estate or inheritance taxes with exclusion amounts that may differ from the federal exclusion amount.