Income Tax Vs. Gift and Estate Taxes
There are two major forms of federal taxes: income taxes and estate taxes. Income taxes are based on how much taxable income you make each year. Estate taxes are transfer taxes that are based on the value of your estate at death.
Gifts do not directly impact income tax liability. By making a gift, you will not save or owe income taxes, nor can you deduct a gift on your tax return. Gifts may, however, transfer future taxable income from the giver’s account to the receiver’s account.
Gift taxes prevent the transfer of assets from one person to another in order to avoid including them in the estate tax calculation upon death. The Gift and Estate taxes are considered a unified tax system. This means that while gift tax returns may be required for certain transactions, taxes will not be paid on these transactions until one has used up the total amount of their estate tax exclusion which is currently $5,450,000.
There are two important kinds of gifts: reportable gifts for which you must file a gift tax return (form 709) and non-reportable gifts for which no return is required. Reportable gifts can remove future growth of an asset from your estate, but when determining the amount of your taxable estate, the gift amount will be added back into the calculation.
Gifts between spouses are never subject to gift taxes or gift tax return reporting requirements so long as a legal marriage exists. Death transfers from one spouse to another are also exempt from tax regardless of the amount. However special rules apply to spouses who are not U.S. Citizens.
Gifts totaling up to $14,000 per person per year are considered non-reportable gifts. Gifts of greater than $14,000 are reportable and require the filing of a gift tax return unless you are directly paying someone’s educational costs or medical expenses. This amount is subject to an annual adjustment for inflation by the IRS.
When gifts are made in excess of the $14,000, the total gift amount is reported on the gift tax return, but only the amount by which the gift exceeds the non-reportable amount is used to reduce your estate tax exemption amount at death.
Spouses may also elect to make a joint gift of up to $24,000 from either or both spouses’ property without any effect on their estate tax exclusion
amount, but they must file an estate tax return to do so and must make a joint gift election on the return.
When gifts exceed $14,000 ($28,000 for joint gifts), the amount may then be subject to a tax once the estate tax exempt amount has been exhausted, or when the cumulative value of all current and prior taxable gifts exceeds the exemption amount also called the “unified credit.”
For example, if you give someone $25,000 in one year, the first $14,000 is not subject to tax. The remaining $11,000 must be recorded as a reduction in your allowable $5,450,000 exemption. You pay no tax now, but will only have an exemption for estate tax of $5,439,000.
The tax rate you will pay on this gift in excess of $14,000 per year depends on the amount by which you eventually exceed the $5,450,000 exemption. When your combined taxable gifts and net estate value (at death) exceed this exemption, the tax rate can rise rapidly. It is a potentially stiff tax that starts at 18% and can reach 40%.
Using Gifts For Estate Planning
Making gifts can be used to save on estate taxes. If you know your overall net worth will exceed $5,450,000 at death, you can make use of the $14,000 annual exclusion to reduce your estate and therefore save taxes down the road. If you have a large estate, the savings can amount to upwards of 40 cents on every dollar given away.
Dr. Steven Weil, an Enrolled Agent, operates several businesses, including RMS Accounting (1984) and its division, Bookkeepers Now (1986). With his wife, Theresa, he oversees a staff of 16 full-time, year ‘round employees in their Fort Lauderdale offices. They consult clients on all tax matters, including tax preparation and planning, bookkeeping, payroll, estate planning, audit representation, and other financial services.