Consider a hypothetical couple: we’ll call them Walter and Noreen. They have an estate valued at about $13 million, which they hope to ultimately pass on to their three children and six grandchildren. In 2017, when the Tax Cuts and Jobs Act (TCJA) was passed, they breathed a big sigh of relief, because the new, higher estate tax exemption (in 2018, $22.36 million for married couples) made it significantly less likely that their heirs would have to pay estate taxes in the event of Walter and Noreen’s passing.
But that was six years ago, and now Walter and Noreen are starting to worry again. Why? Because the higher estate tax exemption, along with several other provisions of the TCJA, are set to expire (“sunset”) at the end of 2025—only two years away. Unless Congress passes a new law and the president signs it, the exemption—almost $26 million for couples in 2023—will be cut roughly in half. Given the growth in Walter and Noreen’s portfolio over the past several years and allowing for future potential growth, they are likely to be over the exemption amount that will be in effect after December 31, 2025.
What should Walter and Noreen do? Well, they should obviously make an appointment with their financial and estate planning experts. If they haven’t already, they should consider how the use of trusts and other estate planning vehicles could help them manage their estate in a more tax-efficient manner. But one of the simplest things they can do is adopt a systematic annual gifting strategy to both reduce the size of their taxable estate and transfer significant wealth to their children, grandchildren, and others without creating a tax burden for either the estate or the beneficiaries.
The Gift Tax Annual Exclusion
The gift tax annual exclusion, when properly used, allows an individual to transfer wealth without using their life-time exemption or paying gift taxes. The amount of the annual gift exclusion for 2023 is $17,000.
The exclusion covers gifts an individual makes to each donee each year. For example, a single taxpayer with three children can transfer a total of $51,000 to them every year, free of federal gift taxes ($17,000 x 3 = $51,000). If these are the only gifts made during the year, there is no need to file a federal gift tax return. If the annual gifts given to a donee exceed $17,000, the exclusion covers the first $17,000 and only the excess is taxable. For example, if you gift $18,000 to a donee in a single year, $17,000 is excluded and the $1,000 of excess is a “taxable gift.” However, even taxable gifts that exceed the $17,000 annual limit may result in no gift tax liability thanks to the unified credit (discussed below).
Gift-splitting by Married Taxpayers
If the donor of the gift is married, gifts to donees made during a year can be treated as split between the husband and wife, even if the cash or gift property is actually given to a donee by only one of them. By gift-splitting, therefore, up to $34,000 a year can be transferred to each donee by a married couple, because their two annual exclusions are available. Consider what this could mean for Walter and Noreen. Because they are a married couple, they can combine their gifts to provide as much as $34,000 to as many individuals as they wish in 2023. Potentially, they could give away this amount to each of their two children and four grandchildren, for a total annual gift of $204,000. And as long as their gifts do not exceed the annual gift tax exclusion limit, they will not need to file a gift tax return and the beneficiaries of their gift will owe no federal income tax on the amounts received.
Consent is required on each spouse’s gift tax return in any year gift splitting is elected and should be indicated on any gift tax returns the spouses file. Persons giving away more than the annual exclusion amount should contact their financial advisors regarding the preparation of a gift tax return.
In addition to direct transfers, individuals may take advantage of the annual exclusion and still maintain some control by using trusts or other custodial arrangements. These include the use of Crummey trusts, minor’s trusts, Uniform Gift to Minor Act (UGMA) or Uniform Transfer to Minors Act (UTMA) accounts, and Qualified Tuition Programs (529 Plans).
Qualified Tuition Programs (529 Plans)
Use of a Qualified Tuition Program has some significant advantages. A donor can essentially front-load a 529 plan with up to five years of annual exclusion gifts. For example, if an individual contributes $85,000 to a 529 Plan in 2023, the individual can elect to pro-rate the gift over a five-year period, thus qualifying for the annual exclusion ($85,000 / 5 =$17,000 each year for five years). This amount can be doubled for a married couple.
In addition to the benefit described above, assets deposited in the plan grow tax-free, and withdrawals used for qualified education expenses are exempt from federal income tax (starting in 2017, 529 funds can also be used for qualified expenses related to private K–12 education). Further, the account holder retains control of the assets within the program and can change the beneficiary at any time.
“Unified” Credit for Taxable Gifts
Some gifts that are not covered by the exclusion, and are therefore taxable, may not result in a tax liability. This is because a tax credit is available to cancel the federal gift tax liability on the first taxable gifts that you make in your lifetime, up to the current lifetime maximum of $12.92 million (for 2023; this amount increases to $13.44 million in 2024). However, to the extent you use this credit against a gift tax liability, it reduces (or eliminates) the credit available for use against the federal estate tax at your death. For example, let’s assume you gift $18,000 to a child and you have your entire $12.92 million lifetime exemption available. There is no tax on the excess amount gifted over the annual exclusion of $17,000 because of the lifetime exemption. However, your lifetime exemption is reduced by $1,000 to $12.919 million. For gifts that exceed the annual exclusion, a gift tax return should be filed to reflect the taxable gift and/or the amount of taxable gift applied against your lifetime exemption.
Payments made Outside of the Annual Exclusion and Lifetime Exemption
There is an unlimited exclusion from gift tax for amounts paid towards another person’s medical expenses or school tuition. Note that these payments must be made directly to the providers and cannot be “reimbursements.” This exclusion is in addition to the annual exclusion noted above. This means that any payments made directly to the school or medical facility do not count against your lifetime exemption. Also, these types of payments can be made on behalf of both family members and non-related persons.
For some, this article may seem rather detailed and perhaps even confusing. Certainly, the tax code is complex, but for those who are knowledgeable and who have guidance from qualified advisors, it does offer certain advantage. JFS Wealth Advisors, as a fiduciary financial advisor and wealth manager, can provide you with the expertise and guidance you need to utilize applicable provisions of the tax code in creating better outcomes for your estate planning goals. Our guidance and recommendations are always presented with the client’s best interests foremost. That’s why we want our clients to have access to the most updated information on investments, taxation, and other matters. By helping our clients make smart, tax-efficient decisions, we are also helping them meet their most important financial objectives. To learn more, visit our website to view our webinar, “Year-End Tax Tips and Strategies 2023.”
