What You Need to Know about Gift & Estate Taxation

Article Highlights:

• Annual Gift Tax Exemption
• Gift Splitting
• Lifetime Estate Tax Exemption
• Education Exception
• Medical Exception
• Qualified Tuition Plan Contributions
• Spouse’s Unused Estate Tax Exclusion
• States With Estate Taxes
• Why Should You Be Concerned?
• Gift & Estate Tax Rates

Gift and estate taxes are both part of the federal transfer tax system and are interconnected.

Gift tax applies to transfers of wealth during a person’s lifetime. If a person gives another person a gift that exceeds the annual gift tax exclusion ($17,000 in 2023), the giver (also referred to as the donor) may have to pay gift tax. However, there is also a lifetime gift tax exemption ($12.92 million in 2023), which means that a person can give away up to that amount over their lifetime without paying gift tax. When the amount given to another person during any year exceeds the annual exclusion for that year, the donor is required to file a Gift Tax Return (IRS Form 709), even if no gift tax is owed because the donor’s lifetime exemption hasn’t been exceeded. The IRS requires this filing so that they can keep track of how much of the donor’s lifetime exclusion has been used up.

Estate tax, on the other hand, applies to transfers of wealth after a person’s death. The value of the deceased person’s estate is calculated, and if it exceeds the estate tax exemption $12,920,000 in 2023), the estate may owe estate tax.  

The interaction between gift and estate taxes comes into play because the lifetime gift tax exemption and the estate tax exemption are coordinated. This means that any portion of the lifetime gift tax exemption that is used reduces the amount available for the estate tax exemption. For example, if a person gives away $1 million over the annual exclusions during their lifetime and dies in 2023, their estate tax exemption would be reduced to $11.92 million.

Annual Gift Tax Exemption – As of 2024, the annual gift tax exemption is $18,000 per recipient (up from $17,000 in 2023). This means that in 2024 you can give up to $18,000 to as many individuals as you want in a single year without incurring a gift tax or reducing your lifetime estate exemption. If you give more than $18,000 in 2024 to a single individual, the excess amount is subject to gift tax. Thus, for example, let’s say you have 4 children. You can gift each of them an amount equal to the annual gift tax exemption without triggering any gift tax or gift tax reporting requirements or reducing the lifetime estate tax exemption.  Gifts to be counted are cash and property, including birthday and holiday gifts.

Gift Splitting – A husband and wife can each make annual exclusion gifts, thereby increasing the exclusion from $17,000 to $34,000 per year (based upon 2023 amounts). However, only one of the spouses may have available property to give. IRC Section 2513 allows the spouses to elect (on a Form 709) to treat a gift made by one spouse as being made by both spouses. 

Example – Gift Splitting – John and Jane are married and have two children. In 2023 when the annual exclusion limit is $17,000, they would like to exclude $68,000 ($17,000 x 2 donors x 2 donees) in gifts. Jane received a large inheritance some years back; John has only a modest estate.  Jane gives the children $34,000 each. Then the couple elects to gift split so that the $34,000 gift is treated as given one-half by Jane and one-half by John (or $17,000 each). The gifts all qualify for the annual exclusion.

Lifetime Estate Tax Exemption – As previously discussed, the lifetime gift and estate tax exemption are coordinated, meaning they apply to both gifts given during your lifetime more than the annual exception and assets left at your death. So, if you use part of the exemption for lifetime gifts, only the remaining amount is available to shield your estate from estate tax when you die. However, the lifetime estate exemption is only reduced by gifts you made during your lifetime that exceed the annual gift tax exemption. To keep track of that amount, the IRS requires Form 709, Gift Tax Return, to be filed when gifts exceed the annual exception. 

Medical and Education Exceptions – In addition to the annual gift tax exception there are also medical and education exceptions included in the U.S. tax code that allow individuals to make certain types of payments on behalf of others without those payments being subject to the gift tax. They include:

• Education Exception: Any payments made directly to an educational institution for someone’s tuition are not considered taxable gifts, regardless of the amount. This means you could pay for a child’s, grandchild’s, or even a friend’s tuition costs without incurring the gift tax. However, this exception only applies to tuition costs. Other expenses, such as books, supplies, or room and board, are not covered by this exception. Contributions to a Sec 529 plan don’t count for this exception but have their own rules (see below).
• Medical Exception: Like the education exception, any payments made directly to a medical care provider for someone’s medical expenses are not considered taxable gifts. This includes payments for procedures, treatments, and hospital stays. In both cases, it’s important to note that the payments must be made directly to the institution or provider. If you give the money to the individual for them to pay the expenses, it will not qualify for the exception.

Sec 529 Qualified Tuition Plan Contributions – Section 529 plans, also known as Qualified Tuition Programs, are tax-advantaged savings plans designed to encourage saving for future education costs. Contributions to a 529 plan are considered completed gifts for tax purposes and are subject to the gift tax rules.

Since under the annual gift tax exclusion an individual can give up to the annual gift tax exclusion amount to another individual without triggering gift taxes or reducing the donor’s lifetime gift and estate tax exclusion, this means that the amount of the annual gift tax exclusion can be contributed to a 529 plan for a beneficiary without incurring gift tax.

However, 529 plans have a special provision that allows for a five-year gift tax averaging. This means that you can contribute up to five times the annual gift tax exclusion amount in a single year and spread the gift evenly over five years for gift tax purposes. This allows you to make a large contribution to a 529 plan without incurring gift tax, if you don’t make any other gifts to the same beneficiary during the five-year period. 

If you contribute more than the annual gift tax exclusion amount or the five-year averaged amount to a 529 plan, the excess may be subject to gift tax and could also reduce your lifetime gift and estate tax exclusion.

It’s also important to note that while contributions to a 529 plan are considered completed gifts and leave your taxable estate, you still retain control over the assets in the plan. You can decide when withdrawals are made and for what purpose, and you can even change the beneficiary of the plan.

Spouse’s Unused Estate Tax Exclusion – “Portability” is a provision in the U.S. tax code that allows a surviving spouse to use any unused portion of the deceased spouse’s estate tax exclusion. This can effectively increase the amount that the surviving spouse can transfer tax-free at death.

As of 2023, everyone has a lifetime estate and gift tax exclusion of $12.92 million. If a spouse dies and their estate does not use up all this exclusion, the unused portion can be transferred to the surviving spouse. This is referred to as the Deceased Spousal Unused Exclusion (DSUE).

Using 2023 as an example, say the husband dies and uses $5 million of his $12.92 million exclusion. His wife could add his remaining $7.92 million exclusion to her own exclusion. Assuming she dies in 2024 when the inflation adjusted exclusion is $13.61 million, her estate tax exclusion would allow her to transfer up to $21.53 million tax-free at her death.

To take advantage of portability, the executor of the deceased spouse’s estate must make an election on a timely filed estate tax return (Form 706), even if the estate is not otherwise required to file a return. The return must include a computation of the DSUE amount.

It’s important to note that portability applies only to the last deceased spouse. So, if a surviving spouse remarries and is again widowed, they can use the DSUE from the most recently deceased spouse, not from both.

Having an estate tax return prepared is generally expensive and a surviving spouse may choose to forgo having one prepared thinking his or her estate will not be large enough to benefit from their deceased spouse’s unused exemption amount. That decision should be well-thought-out not knowing what the future might hold, and considering the exemption amounts can be changed at the whim of Congress. In fact, the amounts established by the Tax Cuts & Jobs Act of 2017 expire after 2025, and the exemption, without Congressional action, would revert to about $6 million.

Should the surviving spouse decide to forgo filing for the deceased spouse’s unused exemption amount, he or she should expect their tax preparer to ask them to sign a statement to that effect, so beneficiaries will not hold the tax preparer responsible should the unused exemption be needed. 

Portability can be a valuable estate planning tool, especially for couples whose combined estates may exceed the individual estate tax exclusion. However, it’s also important to consider other estate planning strategies, as portability does not apply to the generation-skipping transfer tax and some states do not recognize portability for state estate tax purposes.

States With Estate Taxes – As of 2023, the following states levy some form of estate tax: Connecticut, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington.

In addition, the following states have inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.   

Why Should You Should Be Concerned? Because you want as much of your estate as possible to go your designated beneficiaries rather than to government taxes. Currently, at least until the Tax Cuts and Jobs Act expires after 2025, the federal estate tax rates range from 18% to 40% with taxable amounts more than $1 million taxed at 40%.

If you have questions or would like an appointment to discuss how these issues might apply to your specific situation, please give this office a call.