Annual exclusion gifts

Posted On: SEPTEMBER 2021

A deceptively powerful estate planning strategy

In 2021, the federal lifetime gift and estate tax exemption amount is a whopping $11.7 million. So, for most people, it may seem like planning for gift and estate taxes is unnecessary. But even if your net worth is only a fraction of the current exemption amount, there are good reasons to adopt strategies — such as making regular annual exclusion gifts — to reduce the size of your taxable estate.

What is the annual exclusion?

The annual exclusion allows you to make yearly tax-free gifts up to $15,000 per person to any number of recipients. If you’re married, you and your spouse can give up to $30,000 per recipient tax-free. And you can make these gifts without using up any of your federal lifetime exemption amount. You can also make direct payments of tuition or medical expenses on behalf of your loved ones without using your annual exclusion. (See “Don’t overlook tuition and medical expenses” below.)

The annual exclusion amount may not seem all that significant, but along with a regular program of lifetime giving, the benefits can add up quickly. Consider this example: John, a widower, has four children and 10 grandchildren. Starting in 2021, he gives each child and grandchild annual exclusion gifts of $15,000 each, for a total of $210,000 per year. By 2025, he has reduced his taxable estate by $1.05 million, plus any appreciation on the transferred assets, without using any of his lifetime exemption amount. If he also makes direct payments of tuition or medical expenses for any of his children or grandchildren, he can further reduce the size of his estate.

Why make annual gifts?

That’s all well and good, you may be thinking, but what’s the point? If there’s little chance that your estate’s worth will even approach the lifetime exemption amount, is there any advantage to making tax-free annual exclusion gifts? The answer, for many people, is yes.

The most important reason for annual gifting is to protect yourself against the risk that the exemption amount will be drastically reduced in the near future, potentially exposing a portion of your wealth to gift and estate taxes overnight. A “sunset” provision in the Tax Cuts and Jobs Act, which doubled the exemption amount to its current level, calls for it to return to its previous level in 2026.

So, without any action by lawmakers, the exemption will drop to $5 million-plus (adjusted for inflation) after 2025. But President Biden’s tax proposals call for the exemption to be reduced even further, to $3.5 million in bequests at death and only $1 million in lifetime gifts.

Going back to our example, suppose that John dies in 2026, leaving an estate worth $3.5 million, and that the exemption amount in 2026 has been reduced to $3.5 million. John’s estate is shielded from estate taxes by the exemption, but had he not transferred wealth to his family through regular annual exclusion gifts, his estate would have been $1.05 million higher (plus any appreciation on the assets he retained), resulting in an estate tax liability of at least $420,000 at the current 40% rate.

A program of annual exclusion gifts offers nontax benefits as well. These include the chance to watch your loved ones enjoy sharing your wealth and the opportunity to help shape your heirs’ behavior (by conditioning gifts on staying in school, for example).

Should you consider larger gifts?

The current lifetime exemption amount creates a window of opportunity for affluent families to transfer significant amounts of wealth tax-free. So, if you’re willing and able to do so, it may be advantageous to make very large gifts now, before that window closes.

Keep in mind, however, that if you own assets that have appreciated significantly in value, or that you expect to appreciate in the future, gifting them to your heirs may have income tax consequences. Assets transferred by gift retain your tax basis, which means your heirs would trigger an immediate income tax bill by selling them.

Assets transferred at death, however, receive a “stepped-up basis” equal to their date-of- death market value, eliminating any taxable gain as of that date. Note, however, that one of President Biden’s tax proposals would eliminate the stepped-up basis at death.

The gift that keeps on giving

If you’re not able to make very large gifts now, consider implementing a program of regular annual exclusion gifts. This strategy will allow you to transfer substantial amounts of wealth tax-free over time, while minimizing the impact of future reductions of the lifetime exemption. Contact us for more information.

Sidebar: Don’t overlook tuition and medical expenses

In addition to annual exclusion gifts, you can also avoid gift tax on any amount of direct tuition or medical expenses you pay on behalf of your loved ones, without using any of your lifetime gift and estate tax exemption. To qualify for exclusion, payments must be made directly to the educational institution or medical provider. The exclusion applies to tuition at any grade level, but not to room and board, supplies, or other nontuition educational expenses. Medical expenses qualify only to the extent that they’re not reimbursed by insurance.

Consider talking to your loved ones before making annual exclusion gifts to find out what they plan to use the money for. If it will go toward tuition or medical expenses, consider paying those expenses directly to maximize the amount you can transfer tax-free.

© 2021