Understanding Gift and Estate Taxes

December 20th, 2017

Originally published Jul 05, 2017 on iGrad.com by Melissa Horton

Not many jump at the chance to openly discuss death and its implication on one’s finances, but estate planning is a necessary component of any well-rounded financial plan. Through estate planning, individuals can share specific wishes concerning how assets are divvied up not just at the time they pass away, but during their lifetime and the lifetime of their heirs, too.

Maintaining control over how beneficiaries receive property, cash, investments, or insurance benefits is the most common goal of completing an estate plan, while mitigating the costs associated with estate taxes is a close second. To ensure an estate strategy during one’s life and upon their death is truly what was intended, it’s necessary to understand how estate tax — and its close companion the gift tax — work in practice.

Gift and Estate Taxes

IMAGE CREDIT: Priscilla Du Preez via Unsplash

Breaking Down Gift Taxes

The IRS defines gift tax as a tax placed on a transfer of property when no money is exchanged in the process. For example, a grandparent transferring $15,000 to a grandchild after graduation from college is considered a gift in the eyes of the federal government. However, a gift valued at $14,000 or less to a single person in any given year is exempt from federal gift tax.

Understanding when the gift tax is imposed is a bit more complex than simply recognizing the annual gift limit, though.

Doug Martinson, an attorney specializing in estate planning with Martinson and Beason, P.C. in Alabama, explains, “It is a misnomer that as long as the gift is below the $14,000 limit, no tax is owed by either party. In practice, once a gift exceeds this amount in any one year, the giver of the gift will owe gift tax but only if the individual has given away more than $5.49 million during his or her lifetime.”

The purpose of the relatively high lifetime gifting limit is to allow those with large estates an opportunity to reduce the total of their wealth while they are alive, effectively reducing or altogether avoiding estate taxes owed when the individual passes away.

How Estate Taxes Come Into Play

The federal estate tax works hand in hand with the gift tax, as they both fall under the same unified tax credit.

For the 2017 tax year, that unified lifetime credit is $5.49 million for a single person, and just under $11 million (the single rate times two) for a married couple. Laura French, The Mom Lawyer ® and practicing estate planning attorney with French Law Group states, “In light of the $11 million federal estate tax exemption, many individuals and couples will not fall into a taxable estate situation. However, many people do not realize that their entire estate is included for federal estate tax purposes.”

This means that life insurance benefits, retirement accounts like IRAs and employer-sponsored plans, as well as property, cash, and other investments count toward the total value of the estate for federal estate tax purposes. Any amount above the estate tax credit that is not gifted throughout one’s lifetime is subject to estate taxes on a federal level, and possibly on a state level.

Strategies for Reducing Both Types of Taxes

Although a significant portion of the population does not currently face an estate tax issue, the laws governing estate taxes are constantly in flux, not to mention the fact that many individual states have decoupled from the federal estate tax rules, meaning there may be a much lower limit imposed on the value of one’s estate.

French explains that the annual exclusion for gifting is a powerful way to transfer wealth between generations without eventually facing a substantial tax on assets included in one’s estate. She states, “You may give away $14,000 per year, per person, as many years as you would like, without incurring gift tax or filing obligations. A married couple can gift $28,000 to each child, spouse of a child, grandchild, or another person, which ultimately helps reduce the value of the estate over time.”

Any excess to the $14,000 annual exclusion is charged against the $5.49 million (or $10.98 million for married couples) lifetime credit, meaning there is plenty of room for most to avoid estate taxes altogether.

Tax Complexities to Consider

In strategizing to reduce the amount of an estate, French suggests considering the following concerns to gifting throughout a lifetime.

First, there may be reasons to not gift directly to an individual but instead to do so indirectly, such as through a trust or paying tuition to a university. In these cases, it is important to work with an experienced estate planning attorney before making the gift to ensure it remains in the best position, tax-wise.

Similarly, gifts are considered uncompensated transfers for Medicaid qualification purposes, which means the individuals making the gift could be penalized under the five-year look-back rule imposed by Medicaid.

Complications often arise when aggressive gifting strategies are put in place or business assets are involved, making it crucial to understand the implications before going down that path. French concludes that the use of a trust in certain situations can help reduce the probability of complex tax situations throughout one’s lifetime, as well as the confusion that comes once the individual has passed.

The Take-Away: These Taxes Go Hand-in-Hand

Understanding how the gift tax and the estate tax work together is an important factor in creating and sustaining control over assets, even from the grave. Individuals can save significant dollars for everyone by transferring assets in a way that meets gift tax rules each year, and by utilizing estate planning tools to get the job done right.