Sharing the Wealth: How Lifetime Gift Tax Exemption Works

When it comes to sharing your wealth, there may be no better time than the present.

“Many times, it’s better to give money or assets to your loved ones while you’re still around, rather than wait until after you pass,” advises Hayden Adams, CPA and director of tax and financial planning at the Schwab Center for Financial Research.

In addition to the emotional lift giving brings to those you care about, giving now can also be a savvy tax move for families with substantial wealth. That’s because both the present value and any potential future growth of the gifted assets are removed from your taxable estate.

It’s important to remember that, although the IRS generally doesn’t care when you make a major gift, the timing can make a life-changing difference to your heirs. Giving a smaller amount when your heirs need it, and you're still alive, can be more meaningful for everyone than waiting to pass on a larger amount after you're gone. What matters is what works best for your family.

Just make sure you understand all the rules.

What is the current estate and gift tax exemption?

The IRS allows a lifetime tax exemption on gifts and estates, up to a certain limit, which is adjusted yearly to keep pace with inflation.

For 2021, an individual’s combined lifetime exemption from federal gift or estate taxes is $11.7 million. If married, the joint exemption is $23.4 million. (U.S. citizens also have an unlimited exemption from property they inherit from a spouse.)

You can use all, or part, of your gift and estate tax exemption during your lifetime. Any portion left over then can be used by your heirs to reduce or eliminate estate taxes that might otherwise be owed. That can be a big deal for your heirs, as the current top federal estate tax rate is 40%.

“If the inheritance your heirs receive is subject to the estate tax, your loved ones may not receive all that you had hoped they would,” explains Hayden.

Even if your gifts deplete your entire lifetime exemption, your loved ones could still come out ahead—they would receive your gifts tax-free today and could take advantage of their potential for growth.

However, there are specific giving strategies you can use today that can reduce the size of your taxable estate and leave your gift and estate tax exemption untouched. Here’s how to enjoy giving today and potentially save your family money down the line.

What are some gift tax strategies to reduce the size of your taxable estate?

There is an annual $15,000 gift tax exclusion, also indexed for inflation, for assets you give to individuals. It’s separate from the lifetime gift and estate tax exemption. Using the annual gift tax exclusion ensures that every penny of your $15,000 annual gift is excluded from your $11.7 million lifetime gift and estate tax exemption. And because annual gifts reduce the size of your estate, they also reduce the potential tax liability for your heirs.

Individually, you’re allowed to give that $15,000 annual amount to as many people as you like. If married, you and your spouse may each give $15,000 to an individual, for a total annual gift of $30,000. For example, a married couple could give $30,000 to an adult child, and $30,000 to each of their three grandchildren, for a total of $120,000 each year.

When you and your spouse combine both $15,000 annual exclusions, the strategy is called “gift splitting.” Although you won’t owe any additional taxes to the IRS, splitting gifts may still require you to file a gift tax return—Form 709—for the purpose of documentation.

Making a $15,000 annual gift can be incredibly easy. If you and your spouse aren’t gift splitting, you don’t need to file a gift tax return. Recipients typically owe no tax and aren’t required to file any special tax forms.

What are the rules about giving more than the annual gift tax exclusion?

Suppose you give two grandchildren $20,000 each this year, and you give a family friend $10,000. The gift to the friend doesn’t trigger any gift tax issues, as it’s within the $15,000 annual exclusion. But the gifts to the grandchildren exceed the $15,000 exclusion amount by $5,000 apiece and would require some special care.

The amount that exceeded the $15,000 annual limit could be deducted from your $11.7 million lifetime gift and estate tax exemption. In this example, your lifetime gift exemption could be reduced by a total of $10,000 ($5,000 for each grandchild). Assuming you haven't already used up all your lifetime exemption, you won’t owe any tax on the gifts to the grandchildren. However, you will need to let the IRS know that those gifts exceeded the annual limit by filing a gift tax return.

Which gifts are exempt from federal gift and estate taxes?

In addition to the $15,000 gift-giving strategy, there are other ways you can make gifts that reduce the size of your estate, without eating into your lifetime gift and estate tax exclusion.

The IRS also gives you a tax-free pass when:

• You pay the medical bills for another individual.¹
• You pay the tuition bills of a student.²
• You make a charitable contribution to an exempt organization.

There is no annual limit on the size of these gifts. As far as taxes are concerned, it’s as if those weren’t gifts at all.

One important note regarding medical and tuition bill gifts: The money must go directly to the institutions, rather than to the patient or student you’re helping.

How does giving to a 529 plan affect the gift tax?

If you wish to help fund a 529 college savings plan, the $15,000 annual gift limit comes back into play. In this scenario, you’re allowed to combine five years’ worth of $15,000 gift tax exemptions into an initial $75,000 contribution to one student’s 529 account.

Keep in mind that any additional gifts to that individual during the next five years will put you over the annual giving limit, so your lifetime exclusion will be reduced by those additional gift amounts.

Also, if you die in the five years after you make the gift, a prorated amount of your gift is returned to your estate, but only for tax purposes. The entire amount of money you gave stays in the student’s 529 account.

Your giving plan, going forward

The bottom line is that giving sooner might make more sense, rather than waiting to bequeath your assets after you die. Hayden advises sitting down with a tax and estate professional to consider how a giving strategy fits in with your overall investment plan, and to determine whether it makes sense for you to give now or later.

“For many people, gifting over their lifetime can be a great strategy, so long as they leave themselves enough to live on. With so much at stake, be sure to plan carefully with the help of a professional,” says Hayden.

¹Medical care includes expenses incurred for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body, or for transportation primarily for and essential to medical care. Medical care also includes amounts paid for medical insurance on behalf of any individual.

²Does not include books, supplies, room and board, or other similar expenses that are not direct tuition costs.