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Do you plan to give away your money to charity or your heirs but aren’t sure when you should gift it?
Some people worry that if they do so while they’re still alive and then run into a large, unexpected expense, it could hurt their lifestyle down the road. That’s an understandable fear. Others may believe it’s more tax-efficient to wait until they die before transferring their wealth. Still, a few may adhere to the tenet that they should gift a specific amount each year so their heirs can enjoy the extra money over time. None of these thoughts are wrong…or right. The decision is predicated on an individual’s circumstances. However, there are guide rails that may help you decide which could be right for you.
But before we go any further, it’s important to discuss a bit of background on federal estate tax* and gift tax*. Many people are confused about what they are and how they apply to wealth transfers because often, these terms are used interchangeably even though they have somewhat different meanings. And we’d be remiss if we didn’t remind you that every individual's circumstance differs. Motley Fool Wealth Management does not (and is not permitted to) provide tax advice, and you should always consult a tax professional when making any tax decisions.
Estate tax 101
Misconception: Heirs pay estate tax on everything they inherit.
Here’s the short version. When you die, your heirs don't pay estate tax on everything they inherit, and in many cases, there may be no estate tax at all.
There is a certain amount of assets you can exclude from your taxable estate, and anything your heirs inherit in excess of this limit is subject to estate taxes. In 2023, the lifetime exclusion is $12.92 million for single taxpayers and twice this amount ($25.84 million) for married couples.1 In other words, if you are single and die with $15 million in assets, only $2.08 million will be subject to estate tax. The lifetime exclusion is adjusted each year for inflation, so there’s no way to know for sure what it might be years from now when your heirs might need to worry about it.
We won’t go into the technical details about the estate tax (and there are quite a few), but the key thing we think you should know is that the maximum estate tax rate is 40% on the taxable portion of your estate.
It’s also worth noting that the lifetime exclusion is set to halve in 2026. The Tax Cuts and Jobs Act, which went into effect in 2018, doubled the exclusion amount, and unless Congress decides to enact new legislation to extend some of the tax cuts in the law, it will expire at the end of 2025.
Here’s where it starts to get complicated. The lifetime exclusion refers to the value of your estate when you die and the cumulative value of all taxable gifts you’ve given throughout your life. In other words, if you’ve given a total of $2 million in taxable gifts to your kids over your lifetime, then your lifetime exclusion if you die in 2023 drops to $10.92 million ($12.92 million minus $2 million). Continuing with our previous example of a $15 million estate, the taxable portion would then be $4.08 million.
So, let’s talk about these “taxable gifts.”
Gift tax 101
Misconception: Only cold, hard cash is a taxable gift.
The gift tax is assessed on taxable donations or transfers of assets while you are still alive, and there are a few things to keep in mind.
First, although we’ll discuss some dollar amounts in this section, a gift is defined by the IRS as anything you give away without receiving something of value for it. As an example, if you give your grandchild a car, it can be considered a gift for tax purposes. It doesn’t necessarily have to be money or liquid assets.
There is an annual exclusion that allows you to give away as much as $17,000 per person in 2023, and this is adjusted annually by the IRS for inflation. You can use this to give your money to as many people as you want. For example, if you have three children, all of whom are married, and six grandchildren, you can give $17,000 to each of those 12 people, or a total of $204,000, with no gift or estate tax implications whatsoever. You can make these gifts directly to the individuals or to trusts that they are the beneficiaries of. Better yet, if you are married, you and your spouse both can give $17,000 per person.
Why make these annual gifts? One reason is if you anticipate that the value of your estate upon your death will exceed the lifetime exclusion, gifting year after year can help you strategically reduce the size of your estate over time to minimize or even avoid taxes.
However, if you give someone more than the annual gift tax exclusion in any year, you are required to file a gift tax return with the IRS. For example, if you give your grandchild $50,000 in 2023, you will report the $33,000 in excess of the annual exclusion to the IRS. There’s one big exception to this rule. If you’re making a gift to a 529 college savings plan, you are allowed to make a lump-sum contribution equal to five years of the current annual exclusion ($85,000 in 2023 ), as long as you don’t make any other gifts to that recipient for the rest of the five-year period.2
But here’s the kicker: No, zero, zippo gift tax will be assessed until your lifetime taxable gifts exceed the lifetime exclusion. Think of your gift tax returns as a running total of your taxable gifts that are counted against your lifetime exclusion at your life’s end.
Finally, if there is a gift tax due—let’s say that you’ve used up your lifetime exclusion—you (the person giving the gift)—not the recipient—pay the tax. So once your taxable gifts exceed the lifetime exclusion, you will start paying gift tax on the excess amount each year. The gift tax rates currently range from 18% to 40%.
Reasons you might want to start giving your money away while you’re alive
There are some good reasons you might want to start giving away your wealth while you’re alive. Here are four common ones:
- Although it isn’t the most technical reason, giving your assets to heirs while you’re alive can be very rewarding, as you’ll be around to watch them enjoy their inheritance. For example, you can help your loved ones build financial security or pay for large expenses like college.
- Utilizing the annual gift tax exclusions strategically can lower the value of your taxable estate.
- Giving money to your favorite charities while you’re alive can reduce your estate’s value even more and possibly get you valuable income tax deductions each year in the process.
- The Tax Cuts and Jobs Act doubled the lifetime exclusion, so if you’re worried about it reverting to previous levels after 2025, you can give away your money now to take advantage of the higher amount.
Reasons you may want to wait until you pass to give an inheritance
On the other hand, there can be good reasons not to give away your assets during your lifetime. This isn’t an exhaustive list, but here are some of the most common:
- If you don’t think your estate will have a value in excess of the lifetime exclusion, there likely won’t be any taxable benefit to giving your money away early.
- If you plan to give investments to your heirs, it can be beneficial from a long-term tax planning perspective to wait. For example, appreciated assets such as stocks receive a step-up in basis upon death. In other words, if you paid $20 per share for a stock and it is worth $100 when you die, the IRS will treat it as if your heir paid $100, which could result in substantial capital gains tax savings. On the other hand, assets given during life keep the same cost basis that the original owner paid.
- When giving away your assets while you’re alive, it’s important to consider whether you’re keeping enough of a financial cushion for yourself for unplanned expenses, such as long-term care.
- Giving gifts to people while you're still alive can complicate your tax return. Even if you don’t surpass the lifetime exclusion at the end, you will still need to report the money you’ve given beyond the annual exclusion.
Now, then, or somewhere in between
As you can see, there is quite a bit to think about when it comes to giving your estate away—either in whole or in part. And we’ve just discussed general federal tax implications. Several states have their own estate and gift taxes, and some even have an inheritance tax (paid by the recipient).
For some, gifting while you’re alive makes sense, and for others waiting until you pass is more prudent. Or, the best course of action might be a combination of both annual gifts while you’re alive as well as leaving some of your assets to be distributed after you pass. However, it’s a complicated decision, so we recommend you always consult with your estate and tax professionals whenever you make any tax decisions.
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Footnotes
*This article only discusses federal tax. However, some states also may impose their own tax on wealth transfers.
1IRS.gov. Accessed Mar. 29, 2023. The amounts are for taxpayers who file as single or married filing jointly.
2IRS Form 709 Instructions, 2022
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