The most crucial things to consider when it comes to estate planning are gift taxes, estate taxes, and how they interact; as they can significantly reduce the amount of wealth you pass on to your loved ones. Understanding these taxes can help you make informed decisions about how to structure your estate plan, minimize tax liabilities, and ensure that your beneficiaries receive the maximum benefit possible.
Who is taxed?
The gift tax is paid by the person giving the gift (referred to as the "donor") and is not considered taxable income to the person receiving it (referred to as the "recipient").
What is taxed?
Despite what its name suggests, the gift tax does not apply only to items explicitly given as gifts. According to the Internal Revenue Service's (IRS) definition of gift tax, the tax applies to "the transfer of property by one individual to another while receiving nothing, or less than full value, in return." Consistent with this definition, there are numerous items that one might not think of as gifts yet may still be subject to gift tax, including:
- Forgiving debt someone owes you
- Selling someone something for less than its fair market value
- Giving someone a loan at below-market interest rates
- Adding someone as a joint holder to your bank account
- Transferring your life insurance policy to someone else
- Contributing to someone's college savings plan
What's exempted or excluded?
- The annual exclusion: The annual exclusion is a certain amount you can give to a specific individual each year without incurring any gift tax. The amount is adjusted annually, and in 2023 is $17,000 per individual and $34,000 per couple. If you are wondering why there would be a combined number for spouses, consider the following example: Your child has just graduated from medical school, and as a sign of your and your partner's pride, you decide to buy them a new car that costs $30,000. If you gifted them the car as an individual, you would be liable for gift taxes on $13,000—that is, the value of the gift minus your annual exclusion. On the other hand, when you and your spouse gift the car together, you remain under your combined annual exclusion threshold of $34,000.
- The lifetime gift and estate tax exemption: This is an amount you can either give over your lifetime tax-free, or have exempt from estate taxes, as will be explained in more detail below. The amount is adjusted annually, and for 2023, it is $12.92 million per individual and 25.84 million for couples.
- The Spousal Exemption: Under federal tax law, there is an unlimited marital deduction, which says that any assets given to a spouse are exempt from both the estate and the gift tax.
- Charitable donations and political contributions: These may be exempt from gift tax, but the scope, limits, and other specifics can get rather complicated based on the circumstances. So if you are considering donating to your favorite charity, social welfare organization, or political candidate, it is advised that you consult with your tax attorney first.
- Medical and educational expenses. There are various educational and medical expenses (including insurance premiums) you can pay tax-free—regardless of whether the recipients are related to you or are no longer minors. However, these payments will only be exempt if they are made directly to the educational institution, medical provider, insurer, etc. Note that these payments do not count toward your annual exclusions, so there is no limit to how much you can give under these exemptions without incurring gift tax.
What's the tax rate?
Gifts are taxed at graduated rates, with a minimum of 18% for gifts of $10,000 or less and a maximum of 40% for gifts of more than $1 million (after any annual exclusions).
Who is taxed?
The estate tax is not imposed on any specific person but rather on the estate of the deceased based on the value of their assets. In short, once you pass away, the executor of your estate will conduct an inventory of the estate's assets (e.g., cash, stocks, property, and real estate) and its liabilities (e.g., outstanding debt, loan, and credit card balances, and unpaid bills). After the executor settles all your liabilities, the remaining assets will be distributed per your will (or state law if you didn't make one).
What is taxed?
- Real property
- Personal property, such as vehicles, furniture, artwork, and jewelry
- Intellectual property such as patents, trademarks, and copyrights
- Stocks, bonds, and other financial instruments
- Business interests, such as shares in partnerships, LLCs, or corporations
- Retirement and pension accounts
- Life insurance policies owned by the deceased at the time of death
What's exempted or excluded?
- The lifetime gift and estate tax exemption: In the context of the estate tax, it may be helpful to think of this exemption as a threshold value that an estate must reach before it is subject to tax. The amount is adjusted annually, and for 2023, it is $12.92 million per individual and 25.84 million for couples. However, any portion of the lifetime exclusion used to offset gift tax liability will reduce the amount of the estate tax exemption available at the time of the person's death.
- Donations to charities: Gifts and bequests to charities that meet certain requirements will not be counted as part of your taxable estate.
- The Spousal Exemption: As mentioned above, under federal tax law, there is an unlimited marital deduction which provides that any assets transferred to a spouse will be exempt from both estate and gift tax
- Transfers through trusts: Trusts like the irrevocable life insurance trust (ILIT), the qualified personal residence trust (QPRT), and the grantor retained annuity trust (GRAT) can be used to give life insurance policies, personal residences, or other assets to your loved ones while minimizing or even avoiding estate taxes.
What's the tax rate?
Estates are taxed at marginal rates starting at 18% for the first $0 to $10,000 exceeding the exemption, up to a maximum rate of 40% for any portion of the estate exceeding $1 million.
Depending on your location, your state may impose gift, estate, and/or inheritance taxes. State estate tax rates frequently vary along a sliding scale, and exemption thresholds are substantially lower. For example, Massachusetts has an asset threshold as low as $1 million. State estate taxes may also have different exemptions than those that can be claimed for federal estate taxes, making it even more challenging to preserve your estate.
Inheritance taxes are another type of final tax assessed after death and are not imposed at the federal level. Inheritance taxes are unique in that they specifically target your heirs. If someone inherits your property, they may be liable for inheritance tax. If you reside in a state with either state estate taxes or inheritance taxes, consider consulting with a trusts and estates attorney to ensure your legacy is protected at the federal and state levels.
As you can see, there are many complications and issues with far-reaching consequences that you should consider before making political contributions, donating to charity, or even giving a car to your son or daughter, that can not only have immediate tax consequences but also affect the value of what you leave behind for your loved ones many years down the line after you pass.
AAL can connect you with many experienced trusts and estates attorneys who can advise you on how to best preserve your legacy while taking full advantage of gift and estate tax exemptions.
*Disclaimer: Attorney At Law does not represent all lawyers in all states. There may be differences of opinion. It's always advisable to consult with an attorney when in a legal situation.