Those of higher means often hear about the dreaded gift tax. But how does it work? How does it relate to the inheritance tax? Let’s dig in.
So What is the Gift Tax?
The gift tax is exactly as it sounds, a tax on gifts given to another individual. The tax is incurred by the giver of the gift the year it is provided to another individual. A gift, in this case, is defined as something either freely given or given at an amount below its face value. The reason for this tax is primarily to keep an individual from avoiding inheritance tax by giving away all their money. As such, there is a linkage between the gift tax and the inheritance tax.
Exceptions to What is Considered a Gift
Before we dig in let’s look at what is not considered a gift. According to the government, there are some exceptions to what is considered a gift. The first thing to understand is there is no gift tax between spouses. The real point of the gift tax as stated earlier is to target inheritance loopholes. Since spousal assets are generally considered owned by both individuals (with the exception of in of divorce) there is really nothing to gift as both people generally own the assets.
Medical and Tuition Expense Gift Tax Exclusion
Second, there is an exclusion for paying medical and tuition expenses on behalf of someone else. In general, the gift tax does not apply to these payments so long as they go directly to the provider. This is one of the reasons parents can pay college education on behalf of their kids without being taxed.
A third exception comes to mind. I almost don’t think it’s necessary to say here given how obvious it is. However, I will say it anyway. Charitable donations are also not subject to the tax.
Gift Tax Annual Exclusion
Finally, gifts below a certain threshold are not subject to the gift tax via an annual exclusion. In 2019 an individual can provide a gift of up to $15,000 to an individual without incurring the gift tax. This is a per person gift limit. So I could provide $15K to each of my children in 2019 and still not be subject to the gift tax. In fact, this number is also per gifter. So, in theory, a couple can give $30K per child without incurring the tax. In essence, this allows a parent to do things like buy your kids a used car or give birthday parents without running afoul of the gift tax laws or having to report the gift.
Special 529 Rules
A note, there is a special rule for 529 college savings plan gifts. You can make a lump sum to a 529 plan but spread out the tax recorded amount as if you gave a portion of it each year up to 5 years. So you could give $75K and stay below the gift tax as it would be the same as providing $15K each year. A note, this rule treats the money the same as if you gifted this amount each of the 5 years. So it impacts the amount you can give in future years. Also if you die before the 5-year term is exhausted the amount remaining becomes estate tax-relevant.
Applying the Gift Tax
Now that we’ve defined what is excluded by the tax let’s take a look at how it is applied. Say you and your spouse gave your child $31K as your first give over the limit this year. Would you pay a tax on the gift? Well, no.
Gift Tax Lifetime Exclusion
You see like the inheritance tax there is a deduction. In fact, it is a shared deduction. The inheritance tax and the gift tax lifetime exclusion both ignore the first $11.4 Million of lifetime giving from taxes. What this means is you can give or provide for inheritance up to $11.4 Million combined without paying taxes. Furthermore, this number is again by individual so a couple could give their kids an inheritance of up to $22.8 million. See I told you inheritance and gift taxes were linked. (It is important to note this lifetime exclusion plummets back to $5 Million at the sunset of current tax laws in 2025.)
So let us return to our theoretical example of the parents who gave $31K to their kids in 2019. The $1k beyond the annual exclusion means they now have $22.8 million – $1K to apply to gifting and inheritance for the rest of their lives. ($10 Million- $1K for those that die after the law sunsets). They report the $1K amount to the IRS and otherwise pay nothing now.
What Happens if You Go Beyond the Annual Exclusion?
So what happens if you go beyond the individual and annual limits? You pay taxes on the gift or estate roughly equivalent to individual income tax rates. Quite an expensive cost. The good news is very few people will ever exceed $11.4 Million in gifts.
The Gift Tax Annual Exclusion is a Moving Target Depending on When You Will Die
But there is some bad news. Like the sunset rule in general, the estate and gift taxes are political hot potatoes. If you are only in your 30s or 40s the odds are high the limits and laws about gift and inheritance tax annual and yearly exclusions will change multiple times before your passing. In general, this leads me to one additional thought.
Avoid Recording a Gift against the Annual Exclusion When You are Young
If you are on the younger end of the scale I would make a point of staying below the annual exclusion of $15K for now. You never know what the lifetime exclusion will be 20 years from now. It could end up being extremely low. Not knowing how much that limit will actually be 30 years down the road I feel it is prudent to stay below the annual threshold. As such whatever that future limit is, you have no prior gifts further reducing it. It is extremely unlikely and probably impossible that prior year annual exclusions will ever be calculable and usable for future lifetime tax purchases. But prior lifetime exclusion amounts will probably always be considered.
Have you incurred the gift tax?