Strategies to Help Maximize Your Impact and Minimize Your Tax Exposure
As we near the holidays, giving gifts to loved ones may be on your mind. While a wrapped present is always a kind gesture, the gift of assets can have a long-term impact on a family member’s life. If you’re considering gifting assets to loved ones this holiday season, it’s important to do so in a tax-efficient manner.
What’s the annual gift tax exclusion?
The IRS imposes gift tax rules to prevent taxpayers from giving away their assets before they die in an effort to avoid federal estate taxes. When you give assets to someone, you typically need to report the gift to the IRS, and you may need to pay taxes on the gift. Fortunately, the IRS gives taxpayers some leniency to exclude a certain gift amount each year from reporting and taxes.
In 2023, the IRS permits each taxpayer to give up to $17,000 to a single person during the year without needing to report the gift. For married couples, each spouse can make a gift of up to $17,000 per gift recipient, for a total of $34,000 per recipient. These limits increase to $18,000 and $36,000, respectively, in 2024.
Any gift amount in excess of the annual exclusion must be reported to the IRS and counts toward your lifetime estate tax exclusion. In 2023, taxpayers can exclude up to $12.92 million (double that amount for married couples) from estate taxes. In 2024, the limit increases to $13.61 million per person.
For example, if you decide to give your nephew $20,000 toward a new car in 2023, $17,000 would be excluded from IRS reporting requirements. You would need to report the remaining $3,000 to the IRS, and it would count toward your lifetime gift tax exclusion. However, if you’re married, you could give your nephew $17,000 and your spouse could give him the remaining $3,000 without reporting the gift or reducing your lifetime exclusion amount.
The following tips can help maximize your annual gift exclusion while minimizing your tax exposure.
#1 – Give to multiple loved ones.
If you wish to give to multiple people, you can do so without triggering the gift tax reporting requirements. The $17,000 limit is per donor, per individual recipient, and there’s no limit on the number of individuals you can give to.
#2 – Double your impact with your spouse.
Another way to maximize your impact is by giving with your spouse. You can each give up to $17,000 per year, per individual recipient, for a total of $34,000.
#3 – Contribute to education or medical expenses.
If you wish to give more than the annual exclusion amount, you can make unlimited payments directly to educational institutions or medical providers without impacting your $17,000 per year exclusion or your lifetime exemption.
The key word here is directly, as any money gifted to an individual that’s then used by that person for education or medical expenses doesn’t qualify for this exception. It’s also important to be aware that any money paid directly to an educational institution by a parent can reduce a student’s eligibility for need-based aid, so be sure to carefully weigh the pros and cons of making such a payment. Payments by other relatives or unrelated parties don’t impact eligibility.
#4 – Save for a loved one’s college.
Another option for supporting a loved one’s education goals is to contribute directly to a 529 college savings plan. The IRS allows individuals to “front load” 529 contributions by making up to five years’ worth of gifts in a single year with no tax consequences (up to $85,000in 2023). The main benefit of front loading a 529 is that earnings can compound within the account for a longer period.
Consider the power of compounding in the following example.
Dave and Betty recently welcomed a new grandchild to the family and wish to set aside funds in a 529 plan to help cover the cost of her college education. They don’t want to incur gift tax consequences and are considering two options.
- They can contribute $4,722.22 per year for the next 18 years, which equals $85,000 total. Assuming a 7% average rate of return (compounded annually), the account value would be worth $160,551 in 18 years.
- They can front load their granddaughter’s 529 with an $85,000 contribution in the current year. Assuming a 7% average rate of return (compounded annually), the account would be worth $287,294 in 18 years.
As you can see, the simple act of front loading 529 contributions can yield an additional $126,743 in college savings over 18 years. And, because Dave and Betty are married, they can each front load their granddaughter’s 529 plan with up to $85,000 in a single year. If they choose to do so and front load the account with $170,000, the total account value would grow to $574,588 in 18 years, versus $321,102 if they contributed $9,444 per year for 18 years (assuming a 7% annual rate of return, compounded annually).
It’s important to work with your advisor when making the decision to front load a 529 plan. 529 funds are restricted to education costs, and funds from those plans not used for education-related expenses may incur a penalty and tax. A new option in 2024 will allow $35,000 to be rolled over from a 529 to a Roth IRA, subject to certain rules, but your advisor can work with you to determine the appropriate contribution amount based on your personal goals.
#5 – Give appreciated assets.
Another tax-efficient gifting strategy is to directly transfer appreciated assets, such as stocks. The benefit of doing so is that it saves you from paying capital gains tax on the future sale of those assets. If you give appreciated assets to someone in a lower income tax bracket, such as your children or retired parents, they could potentially sell the stock with no capital gains tax liabilities — or pay capital gains tax at a lower rate, depending on their tax bracket.
If you’re considering gifting appreciated assets during your lifetime, consider this: a common mistake is gifting appreciated assets at the end of one’s lifetime, rather than allowing them to transfer as part of an inheritance. Assets that pass via inheritance are eligible for a step-up in cost basis to their fair market value at the time of the original holder’s death, while assets gifted during one’s lifetime aren’t.
An important note
As you’re considering strategies for gifting assets to loved ones, it’s important to be aware that the current individual lifetime exemption amount of $12.92 million is scheduled to be reduced by 50% in 2025, when the current law is set to sunset. Any gifts made before the reduction won’t be penalized if the gifts exceed the reduced exemption amount, but making the best use of the current, higher exemption involves careful planning prior to the sunset in 2025.
As with all major financial decisions, it’s wise to consult with your wealth manager before implementing any of the above gifting strategies. But don’t worry, Creative Planning is here for you. Our experienced teams work together to help ensure your financial life is optimized and working to achieve your personal financial goals. To get started, schedule a call with a member of our team.