Understanding Gift Taxes, Estate Taxes, and the Lifetime Exemption
Gift taxes are the subject of much confusion. Gifts above the annual exclusion amount are only subject to gift taxes if the giver has exhausted their lifetime exemption. Lifetime exemptions usually change on an annual basis but are also regularly altered by significant changes to tax laws.
Taxes are exceptionally confusing.
In case you’ve ever wondered, the Internal Revenue Code (the IRS’ tax rulebook) is over 4000 pages long (depending on who you ask).
Some sources say it would take over 70,000 pieces of paper to print it out.
No matter which end of the range is closer to the truth, that’s a lot of room for complexity; which is ironic because those codes are supposed to provide clarity to honest people trying to calculate their taxes.
Adding to the confusion is the occasional tax code, policy, or term for a tax that exists, but is rarely actually collected by the government.
Just such an example exists in the Gift Tax.
Technically, we all owe taxes on gifts of cash or other assets we give to others, though the IRS does provide an annual exclusion amount.
But even when givers reach this annual exclusion, many don’t realize they can actually give more without incurring any additional taxes, ever.
There are a few different ways this can be accomplished. To understand how let’s walk through gift taxes step-by-step.
The Annual Exclusion
The IRS limits the amount of money one person can give to another individual, tax-free.
There are a lot of good reasons for this, mostly rooted in the basis that people would engage in a lot of “gift-giving” in order to avoid taxes on estates or the transfer of other assets.
This would be especially true for purposes of legacy planning.
If you could sidestep a litany of taxes for your descendants by just giving them their inheritance before you died, wouldn’t you try to do that?
In fact, many people do, and it can be a wise move from an estate planning standpoint.
So, each year the IRS permits each and every taxpayer to give cash or other assets to whomever they wish, up to an annual exclusion amount.
For 2023, this amount is $17,000 from one person to another. Combine a gift with your spouse and you can give up to $34,000 to any one person.
Have a child and a child-in-law? A married couple could give them $68,000 ($17k x 4) without paying a penny of tax.
There is no limit to the number of people you can give gifts to, just a max on how much you can give to each one.
What if I Give More Than This Amount?
You’d think since the IRS itself calls this whole code a Gift Tax, you’d owe a tax if you gave beyond the annual limit.
But, you don’t. At least, you probably don’t.
You see, in addition to the annual exclusion, the IRS provides everyone with a lifetime exemption.
If you die in 2023, your lifetime exemption will be $12,920,000.
So, let’s review. In 2023, you have:
- An annual exclusion of $17,000, and;
- A lifetime exemption of $12,920,000.
If you go over the annual exclusion amount, the amount you give over and beyond the annual exclusion is deducted from your lifetime exemption.
Buckets and Tanks
Metaphorically, I like to think of this as a system of buckets and a tank. All your gifts have to go through the bucket and/or the tank.
Every year, the IRS gives you an endless number of buckets. This represents your annual exclusion.
You can fill each bucket to your heart’s content for any one person on earth. (Gift taxes do not apply to gifts to spouses of any amount.)
You also get a tank. The tank is your lifetime exemption.
If your bucket starts to overflow, the excess spills over into the tank. At the end of the year, you report to the IRS (on form 709) how much went through the tank from all of your collective bucket spillover.
The amount that went through the tank is deducted from your lifetime exemption. The tank’s volume is reduced by this amount at the end of the tax year and you never get it back.
If you give over and beyond your lifetime exemption, you’ll owe gift taxes on each and every dollar you give to another individual from then on.
If your estate exceeds this lifetime exemption, then the estate will pay estate taxes on the value of the assets that exceed the remainder of your lifetime exemption.
Let’s look at some examples.
Generous George
Generous George has done well in life and loves to share with others.
His net worth is over $20M and he decides to give each of his ten friends $25,000.
At the end of the year, George will need to complete form 709 to report his generosity to the IRS which will make a note on George’s file that his lifetime exemption has been reduced by $80,000.
Why?
Because $80,000 is the amount George gave beyond the annual exclusion amount of $17,000 per person. ($25k/person – $17k/person = $8k/person over; $8k x 10 friends = $80,000)
George lives nine more years total and keeps giving his ten friends $8,000 beyond the annual exclusion, resulting in an $80,000 reduction each year to his lifetime exemption for a total deduction of $800,000.
For simplicity, let’s assume the lifetime exemption in the year George dies is $15M and his estate was worth $25M.
Since George used $800,000 of his lifetime exemption already, the portion of his estate subject to estate taxes is $10,800,000 instead of $10,000,000.
I’m sure George’s heirs will be just fine even with the slightly reduced inheritance.
Logical Linda
Logical Linda is George’s financial equal in every way, only she combines her gifts with her husband, Logical Larry.
As a result, Linda and Larry can give away up $34,000 to their friends and none of their gifts impact their lifetime exemption.
When they pass on, their estate is spared taxes on $800,000.
(Just so you know, estate taxes on $800k is worth $320,000 in 2023. This is 40% of $800k.)
Again, we’re talking about people with mega-millions, but $320k is $320k, and Larry and Linda were able to save it without any extra effort.
Well, with the exception of being married.
Reserve Your Spouse’s Tank!!!
Let’s assume our friends Logical Linda and her husband Larry die at the same time in a tragic accident. In that case, their estate would receive a double lifetime exemption, which in 2023 would be $25.8M ($12.9M x 2).
That means their $25M estate would pass tax-free to their heirs. Pretty significant.
But imagine for a minute that Logical Linda’s dear husband, Larry, passes away 10 years before Linda. What if at her death the estate is worth $25M, but that tax year the lifetime exemption amount is only $15M?
Linda’s estate would owe estate tax on $10M! I’m sure you can quickly do the 40% math on that one.
However, there’s a way for Linda’s estate to “reserve” Larry’s portion of the lifetime exclusion.
If Linda files form 706 within nine months after Larry’s death (though you can ask for another 6 months), she can keep the amount of Larry’s lifetime exemption and add it to her own when she dies.
So, in the example we’ve been using, Larry dies with a $12.9 exemption and Linda dies a decade later with a $15M exemption.
By sending in form 706, $27.9M of their estate would be exempt from the 40% estate tax.
You may observe this example and think that it’s trivial since you’re not worth $25M.
I can empathize.
However, taxes fall firmly in the arena of politics and the goalposts are constantly shifted to meet the agenda of whoever happens to be in power at a given time.
For example, during the last election, President Biden proposed lowering the lifetime exemption to $3.5M. That haircut in the exemption amount would catch many more estates.
If you reserve your spouse’s lifetime exemption, you get to take the whole amount with you no matter where the bar is set when you die.
So keep this tidbit in the back of your mind in case you ever have to settle your spouse’s estate or have a loved one who might benefit from this information.
You could save their estate millions of dollars just by sending the IRS one extra form.
Other Tidbits:
- Many people with high net worth simply give away cash up to the annual exclusion in order to reduce the size of their estate. If you’re doing well enough and can trust your heirs with an early portion of their inheritance, it’s a good way to soften some of the estate tax blow.
- None of the estate or gift tax laws apply to gifts to spouses or gifts to charity.
- UGMAs and UTMAs are also a good way to transfer money to younger heirs, but they don’t amount to very much.
- Elected officials are always kicking around the idea of changing the lifetime exemption. Odds are it will change from time to time, so don’t go planning too much of your life around it.
- Roth dollars are transferred to beneficiaries and aren’t taxed as part of an estate. Thus, Roth IRAs are an excellent estate planning option for very wealthy people.
FAQ’s
How much can I give to others without notifying the IRS?
The annual gift tax exclusion for 2023 is $17,000 per person. However, you can combine gifts with your spouse and receive an exclusion of up to $34,000.
What if I give beyond the annual exclusion?
Amounts that exceed the annual exclusion are deducted from an individual’s lifetime exemption through form 709. In 2023, the lifetime exemption is $12,900,000.
Are gifts to my spouse limited?
No. You can give any amount to your spouse tax-free.
If my spouse dies before me, can I preserve their lifetime exemption?
Yes. You must submit form 706 within nine months after your spouse’s death, though you can request a six-month extension.
