As we begin to consider ways to reduce estate taxes, one obvious solution is to simply give away property before death. While this remains a viable option, Congress has limited the benefit of lifetime gifts by imposing a “gift tax” which actually works in coordination with the estate tax system. Thus, if you give away $1 million, you will owe the same tax as if you died and left $1 million. The $675,000 exemption-equivalent is a single unified credit, which applies to lifetime gifts, and then if not used up during life, to any estate taxes.
Although the gift and estate tax systems are “unified,” there are important exceptions.
$10,000 Annual Exclusion Gifts
Some amazing estate-planning results can be achieved by making “small” gifts each year. The first $10,000 of gifts made by one person to another are free of any estate or gift taxes. There is no limit to the number of tax-free $10,000 gifts per year. Thus, a married couple with three children could give $60,000 per year to the children ($10,000 from each spouse to each child). Over a 10- or 20-year period, this can result in substantial estate-tax savings. The gifts need not be cash, and can include fractional interests in real property or shares in a corporation.
Tax Benefit of Lifetime Gifts vs. Bequests
If you make larger gifts totaling more than $675,000 during your lifetime, you will owe a gift tax now. However, the money you use to pay the gift tax comes out of your bank account now — before you die. In contrast, estate taxes are imposed on the entire lump sum you leave, even though part of it will then be used to pay the tax itself.
This can result in tax savings of up to about 28 percent, but more typical are savings of 10 to 20 percent, for lifetime gifts compared to bequests.
Note that gifts made less than three years before death are included in the decedent’s estate anyway. For this reason, it is rarely advisable to delay gifts, especially if the donor is elderly or in poor health.
Pitfall: Growth Assets, Gift vs. Bequest
Another theoretical benefit — but also a potential disadvantage — of making lifetime gifts comes from the likely growth in the value of property. A $15 million estate today may be worth $30 million a decade from now. If you gave away $10 million today, you would pay a $5 million gift tax, but the recipient could be worth $20 million a decade from now. In contrast, if you left a bequest of $30 million, estate taxes would take more than half, leaving less than $15 million.
However, any growth in the assets after you transfer them would result in a capital gains tax, which might be as large as the estate taxes saved, or even larger (for modest estates). For this reason, lifetime gifts of more than $675,000 are rarely used as an estate-planning vehicle. Comparing the effects of taxes on gift planning is largely a math exercise, as well as a guessing game about what tax rates will apply in the future.
Don’t Forget Charitable Gifts
During the estate-planning process, it is important to consider whether it is appropriate to make charitable gifts or bequests. This can include gifts of any amount to non-profit groups that have provided help to you in the past, educational institutions that you or your family members attended, and to other groups that share your values and goals.
In many cases, the uncertain needs of a surviving spouse and young children may preclude any substantial charitable gifts. This is a decision you must make for yourself.
A gift to a qualified non-profit organization will be completely exempt from income and estate taxes.