What is a gift?
At its most basic, a gift is defined as the transfer of ownership of a property without the expectation to receive something of equal value in return. Gifts are transferred during the owner's lifetime, so they may reduce the value of the owner's estate at death.
Lifetime federal estate and gift tax exclusion
Making a gift does not necessarily transfer tax consequences. The government limits how much an individual can gift during their lifetime without paying federal taxes. For 2020, that limit—the federal estate and gift tax exclusion—is $11.58 million per individual, and that amount generally increases each year based on inflation.
Spouses may be able to combine their exclusions, allowing them to transfer $23.16 million potentially free from federal transfer taxes during their lives or after their deaths. If the first spouse to die doesn't use their entire applicable exclusion amount, the surviving spouse can elect to use the balance through a process called portability. Portability requires the executor of the first-to-die spouse's estate to elect this option on the deceased spouse's federal estate tax return. Portability is typically used with the unlimited marital deduction and does not increase with inflation; it is preserved. Also, note that the generation-skipping tax exclusion cannot be ported. State gift taxes may apply. It is important to work closely with an attorney or tax advisor to assess options.
The annual gift tax exclusion
Gifts for education or medical needs can be unlimited, but must be made to the institution, not the individual, to avoid gift taxes.
The annual gift tax exclusion allows an individual to gift up to a certain value to an unlimited number of individuals each year with no federal gift or estate tax consequences. Under current law, the annual gift tax exclusion amount is $15,000.
State 529 plans offer other tax benefits as well. Distribution from a qualified 529 plan account to pay for qualified education expenses will not generate federal income taxes and—in some cases—will not generate state income taxes.
What about a gift of more than $15,000 to one person?
If an individual gives away more than $15,000 to any one person in a year, a taxable gift is created and the individual must file a federal gift tax return (IRS Form 709). But that doesn’t necessarily mean the individual will owe taxes. Instead, the amount of the gift over $15,000 may simply reduce the $11.58 million combined lifetime federal estate and gift tax exclusion amount. For example, if a father makes a gift of $115,000 to his daughter this year, that transfer creates a potentially taxable gift of $100,000 ($115,000 minus the $15,000 annual gift tax exclusion) and an $11.48 million combined lifetime federal estate and gift tax exclusion amount ($11.58 million minus the $100,000 potentially taxable gift).
Each spouse in a married couple may give up to the full annual gift exclusion to one individual. As a result, a married couple can make gifts of up to $30,000 to an unlimited number of individuals in a single year without any tax repercussions.
Special gifting rules
A hypothetical example
Gifts of $15,000 are made to each of 5 family members or friends. This example assumes the individual didn’t make any gifts in prior years that were allocated to the current year. Again, the key is that no single gift exceeds $15,000 in value.
Beyond the annual gift tax exclusion, an individual may be able to make gifts in certain situations without triggering gift tax consequences. These include:
1. Medical and education expenses
There is no limit on gifts if the assets are used to pay for the medical or education expenses of another person. There is one critical wrinkle: To prevent gift tax implications, the gift must be paid directly to the institution or health care provider. An individual can pay tuition (but not room and board) for a grandchild or any special student in their life, without incurring gift tax or generation-skipping transfer tax, by writing a check directly to the institution. The same rule applies for medical expenses. Such payments are not considered taxable and do not count against annual or lifetime gift tax exclusion amounts.
2. Gifts to 529 college savings accounts
Gifts to 529 college savings accounts are subject to the annual gift tax exclusion. However, there is a rule that effectively enables a donor to "front-load" 5 years' worth of the donor's annual gift exclusion into one year: That means an individual could gift to a 529 plan account 5 times the annual gift tax exclusion amount in one year with no tax repercussions.* At today's $15,000 annual gift tax exclusion amount, that means an individual can transfer $75,000 out of their estate in one year without triggering gift taxes, as long as the money is contributed to an heir’s 529 plan account.
The gifts effectively use up the donor's annual gift exclusion to the recipient for 5 years. So, if the donor contributed $75,000 in calendar year 2020, any further gifts made to that individual for the following 4 years would be deemed as having exceeded the annual gift tax exclusion. That, in turn, would potentially trigger a federal gift tax liability, and, therefore, reduce the donor’s federal lifetime estate gift tax applicable exclusion amount.