When it comes to transferring assets for gift and estate tax purposes, there is much confusion regarding the federal rules. What is an annual exclusion gift? How much can I protect from estate tax when I die? Can I give it away before I die? There are many more questions. Let’s consider these rules: (I am assuming U.S. citizens because the rules may be different for non-citizens.)
- Upon your death, you can protect $3.5 million from estate tax. Although this amount changes on January 1, 2010, virtually everybody knowledgeable in this area expects Congress and the President to extend the $3.5 million amount (or increase it) into 2010 and beyond.
- Prior to you death, you can give away $1 million without paying any gift tax. However, if you do give away $1 million during your life, the amount of the gift is deducted from what you can protect at your death (unless it is an annual exclusion gift – see 3).
- In addition to the $1 million, you can give away $13,000 per year to any beneficiary. This "annual exclusion" amount does not have to be to a family member.
- You can pay education and medical expenses in addition to the $13,000 and the $1 million exemption amount
- If you are the beneficiary of an inheritance under 1) above, or a gift under 2), 3) or 4) above, you do not pay federal tax on receipt of the gift. If there is a tax consequence, it applies to the person dieing or making the gift.
How do these rules apply? Here are some examples:
Ex 1: Mom and Dad have three children. They can each give $13,000 ($26,000) to each of the three children ($78,000). Mom and Dad can make these same gifts each year without any income or gift tax consequence.
Ex 2: Two of the children are married. There are 4 grandchildren. Mom and Dad also have a favorite niece. They can gift on an annual basis another $182,000 without any income or gift tax consequence (7 x $26,000).
Under Ex 1 and 2, Mom and Dad gave away $260,000, saving $117,000 in estate tax upon their deaths ($260,000 x 45% estate tax).
Ex 3: Mom and Dad are really wealthy and desire to give away more than the annual exclusion amounts in Examples 1 and 2. Thus, they gift $2 million to their three children. Now upon their deaths, they will only be able to protect $5 million between them ($3.5 million each x 2 = $7 million - $2 million gifts).
Ex 4: For all the gifts above, the assets come from Mom’s separate brokerage account. Notwithstanding, Dad can join in the gifts even thought he does not own the assets because of "gift splitting." The "gift split" would be reflected by Mom and Dad filing a gift tax return each year of the gift, which provides information to the IRS but does not cause any gift tax.
Why gift now? There are several answers to this question. For example, asset values are low, thus allowing you to remove more from your taxable estate. Also, all appreciation in the assets will be removed from your taxable estate. Further, there are various gift strategies that allow you to discount the value of the transferred assets for gift tax purposes. IRS interest rates that may apply to some of these strategies are also low now, allowing for more to be removed from the taxable estate.
Obviously there is more to gift and estate tax planning, but these are a few of the basic rules.