In Donna Summer’s smash hit, “She works hard for the money,” she sings:
It’s a sacrifice, working day to day, For little money, just tips for pay, But it’s worth it all, To hear them say that they care.
So many parents work hard to give their children a leg-up. But they're often frustrated by the IRS money grab! So, one of the most important financial moves you can make should be to figure out how to get your assets into the hands of the next generation without the IRS taking a massive chunk. After all, the estate tax rates in the United States are as much as 40% under current tax law. Plus, 12 states and Washington D.C. have their own estate taxes they impose on transferred wealth over certain thresholds. Six states even have an inheritance tax, paid by heirs on assets they receive.
It goes without saying that this can end up dramatically reducing what your loved ones receive. So, let’s take a look at how gift and estate taxes work, as well as some of the most effective strategies to avoid them.
Understanding the unified tax credit
Before we dive into ways to reduce gift and estate taxes, it’s important to understand how the system works in the United States.
Estate taxes and gift taxes are both covered by a single tax system. Individuals are allowed to exclude a certain amount of gifts and passed-down assets from their taxable estate, a concept known as the unified tax credit. For 2023, the unified tax credit allows a lifetime gift and estate tax exemption of $12.92 million per person1. Married couples get to double this, so they can exclude $25.84 million.
Here’s how this works. Every year when you make a taxable gift (more on that in the next section), you have to file a gift tax return, using IRS Form 709. You don’t need to actually pay any gift tax in most cases, but the amount of your taxable gift will be deducted from the lifetime exclusion. In other words, if you give someone $1 million, the amount of your lifetime exemption will decline from $12.92 million to $11.92 million. The only way you would have to pay gift taxes during your lifetime is if your cumulative taxable gifts have exceeded the lifetime exemption amount.
Once you die and pass your assets to heirs, the IRS will deduct all of the taxable gifts you’ve made during your lifetime from the annual exclusion amount that is in place for the year you die. If the value of your estate is greater than your remaining lifetime exemption, the difference is subject to estate tax.
Finally, it’s worth mentioning that the lifetime exemption was doubled as a result of the Tax Cuts and Jobs Act in 2018.2 Unless Congress makes it permanent, it’s set to be cut in half after 2025. Keep this in mind when planning.
Using the annual exclusion
Not every gift is taxable. In fact, the IRS allows a $17,000 annual exclusion from gift tax implications.3 Even better, this is a per donor and per beneficiary amount. This means that:
- Married couples can give their heirs $34,000 in 2023 without having to file a gift tax return.
- You can use this exclusion amount to give money to as many people as you want.
Here’s why this can be such a valuable tool. Let’s say that you’re married and 70 years old, and that your estate’s value is significantly greater than your lifetime exemption amount. You have three children (all of whom are married) and a total of eight grandchildren.
This adds up to a total of 14 people. You and your spouse can give $34,000 each to all of your children, their spouses, and your grandchildren. This means that you could give away $476,000 of your assets in 2023, and reduce your estate’s value by this amount, without having to file a gift tax return. And next year, you can do it again.
Pay for education
There are a couple of ways you can help your loved ones pay for educational expenses and reduce your future estate tax liability at the same time.
First is an extension of the annual exclusion strategy known as “superfunding” a 529 plan. In a nutshell, this allows you to contribute as much as five times the current annual exclusion amount to a 529 Savings Plan all at once, with no need to fill out a gift tax return4. For 2023, this means that you can contribute as much as $85,000 to each beneficiary’s account.
The caveat is that if you do this, you can’t give them any additional tax-exempt gifts for the next four years. What you’re effectively doing is using five years of annual giving all at once, and any contributions to a 529 plan in excess of the annual exclusion amount are prorated over a five-year period for tax purposes (so, a $50,000 contribution would be counted as $10,000 per year for five years). But this can be a big one-time reduction in taxable estate value. A couple with 10 grandchildren could potentially give away $850,000 in 2023 with absolutely no gift tax implications.
Second and this can be a big one is that any tuition payments made directly to an educational institution on behalf of someone else is excluded from gift tax implications.5 Directly is the key word here. You can’t simply write a loved one a check and tell them to use it to pay their tuition.
This isn’t just for college any educational level counts. If you have a grandchild who attends a private elementary or secondary school, you could pay tuition on their behalf. And this is in addition to the annual exclusion. For instance, you could potentially pay a private university $50,000 in tuition for your grandchild this year and give them $17,000 cash with no need to fill out a gift tax return. It’s important to note that only tuition payments qualify for this exemption other educational expenses such as meal plans and housing do not.
Pay medical expenses
In addition to college expenses, there is a special gift tax treatment for medical expenses. Specifically, if you pay for someone else’s medical expenses directly to the provider, they don’t count toward your annual exclusion amount or your lifetime unified credit.
So, one way to maximize your tax-advantaged giving to heirs is to have them tell you when they get medical bills, and for you to pay them directly. As an example, let’s say that one of your grandchildren needs to have surgery, and after insurance the family gets a bill for $5,000. You can pay that directly to the hospital (or to the provider listed on the bill), and it will have absolutely no gift tax exemptions whatsoever.
It isn’t just emergency medical expenses and standard costs of care that count. The IRS maintains a list of what it considers to be qualified medical and dental expenses, and you might be surprised at some of the items on the list. Just to name a few, if your heirs see a chiropractor, need eyeglasses or an eye exam, need fertility treatments, need to see a psychiatrist, or want to participate in a stop-smoking program, these are examples of things that you can pay on their behalf. Just make sure you pay the provider directly.6
Should you give real estate, stocks, or cash?
Generally speaking, it’s more advantageous to give your heirs money than assets like homes and stocks while you are still alive.
Here’s why. Let’s say that you’ve owned a home for several decades, and you retire and decide to downsize and move to a condo. You want to give your family home to your child.
However, if you simply give the home to your child, your cost basis comes with it. This can result in a massive tax bill if and when they sell the home. For example, let’s say that you paid $40,000 for your home in 1970 and it’s now worth $1 million. If they were to sell the property today, they could have a $960,000 capital gain. They can use the primary residence exclusion to reduce it somewhat if they live there for at least two years, but you get the idea.
On the other hand, if you leave the house to your child in your will, the cost basis will change to whatever the market value is at the time of your death. This can make a big difference when they eventually sell and is known as the step-up in basis.
The same concept applies to other appreciated assets such as stocks. The short version is it’s usually better to let your heirs inherit things that are worth far more than you paid for them, rather than gifting them while you’re alive.
Like most financial best practices, there are some exceptions. For example, if your heirs are in a very low tax bracket right now, it can still make sense to give them appreciated stock to sell, especially if you simply don’t have enough cash on hand to take advantage of your annual exclusions.
Other benefits of maximizing gift strategies
Maximizing your tax-advantaged giving can be a great way to help avoid a future gift or estate tax bill, but this isn’t the only reason to start giving your money to loved ones while you’re still alive. For one thing, doing so can help you bypass probate on gifted assets, which can take months or even years in certain circumstances. Plus, you’ll actually get to see your heirs enjoy the assets you worked so hard to accumulate.
The bottom line is that the gift and estate tax can be costly if you leave a large estate behind, but it’s also usually relatively easy to significantly lower the taxable value of your assets with some smart planning.
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