Gift and inheritance taxes: why you may never owe a penny

Note: This article is part of Morningstar’s October 2014 special report, 5 Keys to Retirement Investing.

If you’ve ever made a large financial gift to someone – say, a four or five figure check to a child or grandchild – you probably know that there may be tax implications associated with such a gesture. Yet, how the gift tax works remains largely misunderstood.

In a nutshell, the federal government limits the amount of assets that can be transferred from one person to another in a given year without tax consequences. The IRS defines a gift as “any transfer to an individual, directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.” Transfers of assets or property over a specified amount are subject to what is commonly known as “gift tax”. However, the gift tax is not a tax in the traditional sense. If you donate beyond the annual limit — known as the gift tax exclusion — you likely won’t have to pay taxes on the money (or the recipient of your gift). Instead, the amount of the excess will be deducted from your lifetime exemption, or the amount you are allowed to give away over your lifetime before you have to pay taxes (an amount that also applies to settling your estate once that you leave this deadly winding).

The annual limit for gifts from one individual to another – the exclusion of gift tax – is rather high to begin with. For 2014, it’s $14,000 – and the amount is doubled for married couples giving to a single individual. So if you and your spouse both wanted to give money to your child, you could give a total of $28,000 without having to worry about gift tax.

those who give too much
So what happens if you go over that amount? Let’s say your child needs money to cover home repairs or you want to give your grandchild a big check as a graduation gift. For any year in which you exceed the annual gift tax exclusion amount, you must file IRS Form 709 as part of your federal tax return. This lets the IRS know that you have exceeded your annual single-person gift allowance and therefore reduces your lifetime tax exemption amount accordingly. (Note that if you give multiple gifts to more than one person – for example, if you gave $10,000 each to four different people – you will not get the annual gift tax exclusion and you will not you will not be required to notify the IRS. ) If you exceed the annual gift tax exclusion over multiple years, the combined amount of the excess will be used to reduce your lifetime exemption amount.

Gift tax applies to property as well as cash donations. Let’s say you and your spouse decide to downsize and give your daughter your house, which is worth $200,000 on the open market. Only $28,000 of this amount is eligible for the gift tax exclusion, meaning that $172,000 would come from your lifetime gift tax exemption. (One way around this problem: transfer the equity in the home to the child from year to year, being careful not to exceed the annual gift tax exclusion limit each time.)

Certain financial gifts are not subject to the gift tax exclusion. In particular, medical and college fees paid directly to the hospital or facility are not deductible, nor are donations made to tax-exempt charities. So if you wanted to help pay for a grandchild’s tuition, and you made payments directly to the school, that wouldn’t count toward the gift tax exclusion (although that might have a negative effect on the financial support image of the grandchild, as shown here).

There is also a special provision for those who contribute to a beneficiary’s 529 college savings plan. In such cases, the donor can use the five-year value of the gift tax exclusion in a year, provided they don’t make any additional gifts to that person during that time. of five years. So, for example, if a grandparent wanted to help fund a grandchild’s college education by contributing to a 529 plan, they could potentially contribute up to $70,000 in a single year ($140,000 for a couple) as long as the grandparent would not give extra money. gifts to the grandchild over the next four years.

Why gifts are important in estate planning
Although large financial donations probably won’t affect your annual tax bill, tThey could have a financial impact on your estate after your death. This is because the amount of lifetime gifts you have made in addition to your annual gift exclusion helps determine whether or not your estate will be subject to estate tax. When giving financial gifts, during their lifetime or after their death, each individual can benefit from what is called unified credit, which essentially applies the lifetime exemption from gift tax to inheritance tax. This means that as long as donations made during his lifetime and after death do not exceed a certain amount, these donations will not be subject to tax.

Now on to the good news, or at least the good news for those of us whose domains aren’t exactly giant-sized. For 2014, the first $5.34 million of an individual’s estate is exempt from estate tax. This means that unless you have an estate in excess of this amount or have significantly exceeded the annual gift tax exclusion in your lifetime, you will probably owe nothing in inheritance tax. Anything over the $5.34 million limit is taxed at 40%. (The inheritance tax exemption is indexed to inflation, so it usually increases slightly each year.) Additionally, this exemption is transferable between spouses. So if one spouse dies, their unused gift tax exemption can be used by the survivor, meaning they could potentially qualify for an exemption of up to $10.68 million. (To learn more about the portability clause, watch this video.)

Let’s say, for example, that you give $2 million over your lifetime beyond what you have been able to exclude in the years you’ve made the donations.. This means that the amount of your estate over $3.34 million (your unified credit of $5.34 million minus your $2 million in lifetime gifts) will be subject to estate tax. But if your estate is less than $3.34 million, you won’t owe any estate tax because your total lifetime gifts will not have exceeded the exemption amount.

Not so long ago, the federal estate tax exemption was much lower. As recently as 2001, it was just $675,000 per individual with an 18% tax at that level, rising to 55% for estates of $3 million or more. In 2010, the estate tax exemption was increased significantly, to $5 million (and a rate of 35%), and it has since increased slightly, while the rate was increased to 40%. Because of this much higher inheritance tax exemption, few are required to pay it. According to the Center on Budget and Policy Priorities, only 1.4 estates per 1,000 had to pay the tax in 2013..

States do too
But before you rejoice (if that’s the right word) at falling under the threshold for having to pay federal gift or estate taxes, be sure to check whether your state has its own rules. Twelve states and the District of Columbia levy estate taxes, with the exemption amount ranging from the federal exemption ($5.34 million this year) to just $675,000 in New Jersey (for more details on which states have estate taxes and their exemption amounts, see Table 3 of this report by the Minnesota House of Representatives Research Department). Additionally, a handful of states levy an estate tax, which is similar to an estate tax, but generally exempts assets passed on to children and grandchildren. One state, Connecticut, even imposes its own gift tax that works similarly to the federal gift tax.

In general, however, most people will never have to pay taxes on gifts or inheritances they give to others, at least to the extent that federal gift and estate taxes are currently being built. But don’t let that stop you from filing the required paperwork for any large donation. Think of it as a small price to pay for doing an act of kindness.

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