A Tax on Giving – Understanding the Rules of the Gift Tax
Getting taxed once is hard enough, but getting hit a second time on the same dollars? That’s enough to give even a compliant taxpayer the urge to toss crates of tea into Boston Harbor. Whether double taxation like the gift tax is morally right or not is a topic for someone else to tackle. But if you understand the gift tax rules, it’s fairly simple to avoid this painful tax and beat your dear ole’ Uncle Sam at his own game.
The following FAQ should help dispel some common misconceptions about gift taxes, while shedding some light on practical strategies for transferring money and legally avoiding that dreaded double taxation.
Q: Why does the gift tax even exist?
A: It’s there to prevent an individual from circumventing inheritance taxes by giving away all of his or her assets before death.
Q: What exactly constitutes a gift?
A: From the IRS’ standpoint, a gift is basically a transfer of something to another individual, either directly or indirectly, where the donor is not fully compensated for the value given.
Q: Are all gifts taxable? Are there any exceptions?
A: Generally speaking, all gifts are taxable, but the following are not considered “taxable gifts”:
- Gifts that do not exceed the annual exclusion for the year (more on this in a bit)
- Gifts to your spouse
- Medical expenses or tuition paid for someone else – only if paid directly to the medical or educational institution
- Gifts to a political organization for its use
- Gifts to qualified charitable organizations (these gifts are actually tax-deductible donations)
Q: Are gifts to individuals tax deductible?
A: No. The only deduction available for gifts is for donations to qualified charitable organizations.
Q: What is the “annual exclusion” amount for 2020?
A: For 2020, you are allowed to give up to $15,000 to each individual before triggering a taxable gift.
Q: Am I limited on how many “annual exclusions” I can use in a year?
A: No. If you wanted to utilize the full annual exclusion amount for 4 children and 6 grandchildren, you could write out ten checks for $15,000 each for a total of $150,000.
Q: Is the recipient limited to a certain amount of gifts received in a given year?
A: No. The only limit is the same donor cannot give the same recipient (“donee” in IRS-speak) more than the annual exclusion amount in the same year without creating a taxable gift.
Q: What strategies can I use if I want to give more than the annual exclusion amount?
A: A married couple can elect “gift splitting” on IRS form 709 (gift tax return). A married couple can gift $30,000 to any one person per year before exceeding the annual exclusion. Therefore, a married couple giving money to another married couple could gift $60,000 per year – with zero exposure to the gift tax.
Q: Isn’t there some sort of special exception for education funding in a section 529 plan?
A: Only for section 529 plans (tax-favored education funding vehicles), a donor can “front-load” up to five years’ worth of annual exclusion amounts. So an individual could give $75,000 (5 x $15,000), and a couple could give up to $150,000 without it being considered a taxable gift.
Q: What happens if I exceed the “annual exclusion” amount?
A: Any amounts given to any one individual in excess of the annual exclusion amount constitute a taxable gift, and trigger the need to file IRS form 709. However, and this is important: A taxable gift does not necessarily mean – in fact, it rarely means – that any tax needs to be actually paid.
You see, Uncle Sam lets us give away (either during our lifetime via gifts, or at death via bequests) a healthy $11.58 million (maximum for an individual in 2020) before a dime of gift tax needs to be paid. So whenever you give a gift to a single recipient in excess of the annual exclusion amount, the excess amount simply reduces your $11.58 million lifetime exclusion. It’s only after that entire lifetime exclusion has been exhausted that you would be subject to an immediate tax.
Just remember that federal gift tax and estate taxes are unified into one integrated tax system. So your lifetime gift tax exclusion is linked to your estate tax exclusion. Once you’ve exhausted that unified credit amount through gifts, the first dollar in your estate will get taxed. That’s why, for those with potentially taxable estates, it makes sense to avoid eating into your lifetime gifting exclusion to preserve that unified amount for your use as an exclusion for your estate.
Q: Who pays the gift tax, the donor, or the recipient?
A: The donor is responsible for reporting the gift (if necessary), and paying any required gift tax after her lifetime exclusion amount has been depleted.
Q: What is the gift tax/estate tax rate?
A: It’s based on a sliding scale with multiple tax brackets – much like our income tax system. The difference is there are more brackets, and they ramp up more quickly for gifts/estates. The lowest bracket is 18%, and the highest bracket at 40%.
Q: How do the gift tax rules apply with regard to same sex couples?
A: Same sex married couples are treated in the same manner as opposite sex married couples. For example, they are allowed to elect “gift splitting,” and any gifts between same sex spouses are not considered taxable gifts.
As you can see, the gift tax is rarely applied. But when it is, it’s painful. So it’s important to take steps to avoid it. For someone in the top income tax bracket, roughly 37% can be lost due to the income tax, then another few percent for state income tax, then another 40% for gift or estate taxes. Total taxation can easily top 85%, or even 90%, depending on the level of state income tax assessed originally.
However, with proper planning, it’s possible to avoid the onerous gift tax entirely, while still generously giving to those you care about.