The annual gift tax exclusion is widely misunderstood. Many people believe that for tax purposes they must stay under the exclusion limit. In fact, for the vast majority of people, the annual exclusion - currently $14,000 - effectively has no impact.
I can best explain by first examining a related concept: The lifetime unified gift tax and estate tax exemption. This is the maximum amount the federal government permits you to pass, free of federal gift tax (for gifts you make during your lifetime) and free of federal estate tax (for money you pass at your death). The current lifetime exemption is $5,450,000.
The annual gift tax exclusion permits you to give away, free of gift tax, up to $14,000 to any one individual within any calendar year, to as many individuals as you wish. (If married, each spouse may pass that amount.) A gift of less than $14,000 is not deducted (i.e., "excluded") from your lifetime exemption of $5,450,000. A gift under $14,000 does not need to be reported to the IRS.
But what happens if you give a gift to one or more individuals in a calendar year in excess of $14,000? In this case, you have to report the amount over $14,000 to the IRS, which will deduct that amount from your lifetime exemption of $5,450,000. However, until you have given away $5,450,000, you actually owe no tax. Here are two examples to clarify this point:
- Ann has made no gifts during her lifetime and has her full $5,450,000 lifetime exemption. She has three children. She gave $14,000 to each of them in 2015. She was not required to file a gift tax return since none of the gifts exceeded the annual exclusion. She owed no gift tax. Her lifetime exemption remained untouched. She still has the right to pass on $5,450,000, free of estate tax and gift tax.
- John has two children. He has not used up any of his lifetime exemption and has $5,450,000 to give away over the course of his lifetime, tax-free. In 2015 he gave $54,000 to his daughter to help her purchase a home. He also gave $14,000 to his son. Since the gift to his daughter exceeded the annual exclusion, John had to file a gift tax return. The IRS deducted the amount over $14,000 he gave to his daughter ($40,000) from his lifetime exemption. John is now left with $5,410,000 to pass tax-free for the rest of his life (and/or at death). He does not actually owe any tax on the $40,000.
In short, any gift over $14,000 to any one individual in any one calendar year requires you to file a gift tax return. But you owe no taxes until such time as you've used up your $5,450,000 lifetime exemption. This is why, for the average American with more modest assets, the $14,000 annual exclusion is effectively meaningless.
But let us not give short shrift to those who do have assets in excess of $5,450,000 and eager to pass as much tax-free money as possible to heirs. If this describes your situation, you have several methods at your disposal that allow you to pass more than $14,000 tax-free per year to one or more individuals. You may, for example, pay for someone's school tuition in any amount, so long as you pay the educational institution directly. This is what many of my wealthier clients do for their grandchildren. You get a similar tax break for any amount you pay for an individual's medical care, provided the funds go directly to the medical provider. Talk to our attorneys about these and other tax-savings strategies.
Last, a word to everyone, regardless of net worth: Laws are always changing as economic and political winds shift. Fifteen years ago the lifetime exemption was $675,000. Two years ago the annual exclusion was $13,000. Depending on where the tax laws head, you may need to do some tweaking of your estate plan, as well as revisit your plans to make gifts to your loved ones. As far as taxes go, nothing is ever set in stone, so for your and your family's benefit, it's wise to stay informed.