Gift and Estate Taxes: Why You Might Never Owe a Penny

Note: This article is part of Morningstar's October 2014 5 Keys to Retirement Investing  special report.

If you've ever given a sizable financial gift to someone--say, a four- or five-figure check to a child or grandchild--you're probably aware that there can be gift tax implications tied to such a gesture. Yet, how the gift tax works remains widely misunderstood.

In a nutshell, the federal government limits the amount of assets that can be transferred from one person to another in a given year without tax consequences. The IRS defines a gift as "any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return." Transfers of assets or property above a set amount are subject to what is commonly known as the "gift tax." Yet, the gift tax isn't a tax in the traditional sense. If you give a gift above and beyond the annual limit--known as the gift tax exclusion--you probably won't have to pay any taxes on the money (nor will the recipient of your gift). Rather, the amount of the overage will be deducted from your lifetime exemption, or the amount you are allowed to give away over the course of your entire life before you must pay taxes (an amount that also applies to the settling of your estate once you depart this mortal coil).

The annual limit for gift-giving from one individual to another--the gift tax exclusion--is rather high to begin with. For 2014, it's $14,000--and the amount is doubled for married couples giving to a single individual. So, if you and your spouse both wanted to give money to your child, you could give a combined $28,000 without having to worry about the gift tax.

Givers Who Give Too Much
So, what happens if you go over this amount? Let's say your child needs money to cover house repairs or you want to give your grandchild a large check as a graduation gift. For any year in which you exceed the annual gift tax exclusion amount, you are required to file IRS Form 709 as part of your federal income tax return. This lets the IRS know that you have gone over your annual allotment of gift-giving for a single individual and, thereby, reduces the amount of your lifetime gift tax exemption accordingly. (Note that if you give multiple gifts to more than one individual--for example, if you gave $10,000 apiece to four different people--you wouldn't hit the annual gift tax exclusion and you would not be required to notify the IRS.) If you exceed the annual gift tax exclusion in multiple years, the combined amount of the overages will be used to reduce the amount of your lifetime exemption.

The gift tax applies to property as well as cash gifts. Let's say you and your spouse decide to downsize and give your daughter your house, which is worth $200,000 on the open market. Only $28,000 of that amount is eligible for the gift tax exclusion, meaning that $172,000 would come out of your lifetime gift tax exemption. (One way around this: Transfer equity in the home to the child year by year, being careful not to exceed the annual gift tax exclusion limit each time.)

Some financial gifts are not subject to the gift tax exclusion. In particular, medical and college costs paid directly to the hospital or institution do not count against it, nor do donations made to tax-exempt charities. So, if you wanted to help pay a grandchild's college tuition and made payments directly to the school, it would not count against the gift tax exclusion (although it might have a negative effect on the grandchild's financial aid picture, as discussed here).

There's also a special provision for those contributing to a beneficiary's 529 college-savings plan. In such cases, the giver may use five years' worth of the gift tax exclusion in one year, provided that he or she doesn't give any additional gifts to that individual over that five-year span. So, for example, if a grandparent wanted to help fund a grandchild's college education by contribution to a 529 plan, he or she could conceivably contribute up to $70,000 in a single year ($140,000 for a couple) as long as the grandparent gave no additional gifts to the grandchild over the next four years.

Why Gifting Matters in Estate Planning
Even though large financial gifts probably won't affect your annual income tax bill, they could have a financial impact on your estate after you die. That's because the amount of lifetime gifts you've made over and above your annual gift exclusion helps determine whether or not your estate will be subject to the estate tax. When making financial gifts, either during life or after death, each individual can take advantage of what's called the unified credit, which basically applies the lifetime gift tax exemption to estate taxes. That means that as long as gifts made both during one's lifetime and after death don't exceed a certain amount, those gifts won't be subject to taxes.

Now for the good news, or at least good news for those of us whose estates aren't exactly jumbo-sized. For 2014, the first $5.34 million of an individual's estate is exempt from estate taxes. That means that, unless you have an estate larger than that amount or you have substantially exceeded the annual gift tax exclusion over the course of your lifetime, you likely will owe nothing in estate taxes. Anything above the $5.34 million limit is taxed at 40%. (The estate tax exemption is indexed to inflation, so it generally goes up slightly each year.) Plus, this exemption is portable between spouses. So, if one spouse dies, his or her unused gift tax exemption can be used by the survivor, meaning he or she could conceivably have an exemption of as much as $10.68 million. (For more on the portability provision, check out this video.)

Say, for example, you give away $2 million during your lifetime above and beyond what you were able to exclude in the years in which you made the gifts. That means that the amount of your estate that is over $3.34 million (your $5.34 million unified credit minus your $2 million in lifetime gifts) will be subject to the estate tax. But if your estate is smaller than $3.34 million, you won't owe any estate tax because your total lifetime gifts won't have exceeded the exemption amount.

Not so long ago, the federal estate tax exemption was much lower. As recently as 2001, it was just $675,000 per individual with an 18% tax at that level, which climbed up to 55% for estates of $3 million or more. In 2010, the estate tax exemption was raised significantly, to $5 million (and a 35% rate), and it has increased slightly since, while the rate was boosted to 40%. As a result of this much higher estate tax exemption, few are ever required to pay it. Just 1.4 estates per 1,000 were expected to owe the tax in 2013, according to the Center on Budget and Policy Priorities. 

States Do It, Too
But before you rejoice (if that's the right word) at falling below the threshold for having to pay federal gift or estate taxes, be sure to check to see if your state has any rules of its own. Twelve states and the District of Columbia levy estate taxes, with the exemption amount ranging from the federal exemption ($5.34 million this year) down to just $675,000 in New Jersey (for details on which states have estate taxes and their exemption amounts, see Table 3 of this report by the Minnesota House of Representatives Research Department). Also, a handful of states levy an inheritance tax, which is similar to an estate tax but which typically exempts assets passed on to children and grandchildren. One state, Connecticut, even imposes its own gift tax that works similarly to the federal gift tax. 

In general, however, most people will never have to pay any taxes on the gifts or inheritance they give to others, at least as the federal gift and estate taxes are currently constructed. But don't let that stop you from filing the required paperwork for any large gifts. Consider it a small price to pay for committing an act of kindness.