For an update, please see my Oct. 30, 2014 post, "IRS Raises Limit On Tax-Free Lifetime Gifts For 2015."
This is the time of year when people think about being generous to family and friends. Especially for those who have been less fortunate, the impulse is to just write them a check.
Unfortunately, it’s not that straight forward. You must follow the same rules that would apply to any other lifetime transfers, including those intended mainly to pare down your estate and leave less for the government to tax.
The bottom line: Gifts of cash or other assets can count against your exclusion from gift or estate tax, which this year is $5.25 million and goes up to $5.34 million in 2014. If you exceed this basic exclusion amount (sometimes called the “unified credit” or the "lifetime gift-tax exemption") you could wind up owing gift tax of up to 40%. Even if you don’t, your lifetime gifts would reduce how much you can pass tax-free through your estate plan.
While generosity often occurs under the radar, the law is clear. If the gift exceeds a certain value and the Internal Revenue Service catches it, you could be forced to pay the tax as well as interest, and, in some cases, penalties.
Here's how to use the yearly and lifetime limits to best advantage and avoid lurking tax traps.
1. Write a check for up to $14,000. The simplest way to subsidize others is by using the annual exclusion, which allows you to give $14,000 in cash or other assets each year to each of as many individuals as you want. Spouses can combine their annual exclusions to give $28,000 to any person tax-free – a process called gift-splitting. For example, a married couple with a child who is married and has two children could make a joint cash gift of $28,000 to the adult child, the child’s spouse and each grandchild – four people – providing the family with $112,000 a year. Gifts that exceed the annual exclusion count against the lifetime exclusion (currently $5.25 million).
Feeling very generous? Write two checks: one before Dec. 31 for $14,000, and the other on Jan. 1 for $14,000, giving the recipient a full year’s worth of potential investment growth on the second gift. (The annual exclusion will not increase in 2014.)
2. Fund college savings plans. Federal law allows you to contribute to Section 529 education savings plans up to the annual exclusion amount. You can set up a separate account for each family member whom you wish to benefit. Although your contributions to a 529 account are considered gifts, money in these accounts grows tax-free and can be withdrawn tax-free, provided it is used to pay for college, a graduate, vocational or another accredited school, or for related expenses.
The law also permits lump-sum deposits of as much as $70,000 per person at once ($140,000 for married couples), but you must file a gift-tax return electing to treat the gift as if it had been spread over five years. (For more about this important tax form, see "Gift Tax Returns: What You Need To Know.") During this five-year period, you cannot make additional annual exclusion gifts to the person you are benefiting with the 529 plan.
If you previously set up these accounts, you can top them off with another $14,000 gift, if you have been funding them year by year. For plans funded with a five-year election, you can add a nominal sum to make up for the difference between the current annual exclusion of $14,000 and what it was when you set up the plan. So if you set it up any time between 2009 and 2012, when the annual exclusion was $13,000, you can add $1,000 as this year’s gift – you can’t go back over past years, says Susan T. Bart, a lawyer with Sidley Austin in Chicago. On the other hand, if the five years has expired, you can add the full $14,000 this year.
If the plan beneficiary is now attending college and you are wealthy enough that your estate could be subject to tax down the line, you might want to refrain from making any more contributions to 529 plans and instead pay the tuition directly, says Bart. Without using your annual exclusion, you can pay for tuition (and dental and medical expenses) of anyone you want. These are considered tax-free gifts as long as you make the payments directly to the providers of those services – you can’t just reimburse the person whom you want to benefit. Funds in the 529 account can still be used for expenses that you can’t pay directly, such as room, board and books. (See "Paying For College: What Every Parent (And Grandparent) Needs To Know About UTMA Accounts.")
3. Top off large 2012 gifts. One thing that makes annual exclusion gifts so appealing is that they pass outside of the transfer tax system and don’t count against the $5.25 million that you can currently give away tax-free during life or at death.
Until Congress passed a new tax law last New Year’s Eve, the tax-free amount was scheduled to automatically dip to $1 million per person. The tax deal that averted the fiscal cliff prevented that from happening. (See my post, “After The Fiscal Cliff Deal: Estate And Gift Tax Explained.”)
Not having much faith in Congress and at the urging of their financial advisors, greedy descendants or golf buddies, some wealthy folks rushed to make lifetime gifts that would pare down their estates – just in case the “opportunity” to give away what was then a tax-free amount of $5.12 million went poof. It made sense at the time: lifetime gifts leave less for the government to tax when you die, and if the assets increase in value after you have passed them along, you will not owe gift tax on the appreciation.
The urgency to make large lifetime gifts no longer exists. The American Taxpayer Relief Act of 2012, passed in the closing hours of last year, maintained the high exclusion amount. Then on Jan. 11 the IRS made an inflation adjustment to raise it even higher for 2013 – to $5.25 million. With the latest adjustment, announced Oct. 9 in Revenue Procedure 2013-35 it goes up again in 2014, to $5.34 million.
The question now, for people who made large gifts last year, is whether they want to top them off with the additional $130,000 ($5.25 million minus $5.12 million) available for tax-free gifts this year. Before you do, consider what effect your gift has had on the recipients, whether it went to them directly or to a trust for their benefit, advises Bart. Did they use it for daily living expenses, to build a nest egg, or blow it on a shopping spree for luxury items? If you have second thoughts, don’t make additional gifts even though they might make good tax sense. (See “Why Family Wealth Is A Curse.”)
Another way to use this extra exclusion amount is to benefit a descendant who was born after your initial planning, and is therefore not a beneficiary of earlier gifts – made either with the annual exclusion or the lifetime tax-free amount, says Evelyn Capassakis, a tax principal in PwC’s Private Company Services Practice. This might be a grandchild or even a child, if you didn’t think you would have any more children, and then you did. (See “James Gandolfini’s Will Reflects A Parent’s Dilemma.”)
But really, this is a decision that applies to a rarefied few. Most people never use the lifetime exclusion amount, especially now that married couples can add any unused exclusion of the spouse who died most recently to their own. (See my post, “The Deadline Every Married Person (And Financial Advisor) Needs To Know About.”) This enables them together to transfer up to $10.5 million tax-free ($10.68 million starting in 2014) not only during life, but also at death – something they couldn’t as easily do before 2011.
4. Document values. If you make a gift of anything other than cash or marketable securities, you need to get a professional appraisal at the time you make transfer, especially if it is a hard to value asset, like a piece of real estate or a share in the family business, advises Capassakis. By making one gift late this year and another early next year, you can rely on the same appraisal for both gifts, which saves transaction costs.
5. Send annual Crummey notices. One condition for the annual exclusion is that the gift must be a present interest, meaning something the recipient can use right away, rather than a future one. That’s not a problem but if you make gifts of cash or other assets directly to the recipients. But if you use the annual exclusion to fund trusts, you must satisfy the present interest requirement another way.
The most common way to do that is to give beneficiaries Crummey powers: the right for a limited time, usually 30 or 60 days, to withdraw from the trust the yearly gift attributable to that beneficiary. Each year, the trustees must send a notice, called a Crummey notice, to the beneficiaries (or the parents, if the beneficiaries are minors) letting them know about their right to withdraw their portion of the annual gift to the trust.
Although there’s nothing difficult about preparing these notices – some lawyers will even give you a template – many people neglect to send them and to keep copies with the trust documents. “More and more, in gift tax audits, the IRS is asking for those Crummey letters,” says Capassakis. This could also come back to bite your heirs later if your estate is audited. In the worst-case scenario they could get stuck paying back gift taxes for the money you put in the trust.
6. Tally up your gifts. Many people who intend only to make gifts within the annual exclusion amount wind up going over the limit because they lose track of what they’ve already given away, Capassakis says. One context in which this happens is when people are using Crummey powers to fund life insurance trusts. They forget that the yearly value of the gift to the trust is allocated to the beneficiaries – however many there are. Then they fund 529 plans for the same people who are beneficiaries of the life insurance trust, overlooking the fact that they’ve already in effect made a gift to that person. This excess gift eats into their lifetime exclusion amount.
For example, let’s say you are putting $3,000 dollars a year into a life insurance trust, so it can pay the premiums on a policy for which your child is the beneficiary. At the same time, you want to add funds to a 529 account that you set up to benefit the same child. In this example, if you want to stay within the annual exclusion for 2013, your contribution to the 529 plan should not exceed $11,000.
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Archive of Forbes Articles By Deborah Jacobs
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide, now available in the third edition. You can follow her articles on Forbes by clicking the red plus sign or the blue Facebook “subscribe” button to the right of her picture above any post. She is also on Twitter and Google+
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