It’s that time of year again. Whether you celebrate Christmas, Hanukkah, Kwanza, Winter Solstice, or nothing at all, chances are you’re still looking for gift ideas for your loved ones.
Fortunately, Uncle Sam’s Tax Code contains a variety of provisions that allow you to get a tax break when you give a gift. But it’s important to do it right to avoid potential pitfalls.
First, some background. You can give anyone cash or assets valued up to $15,000 every year with no tax implications and better yet, no paperwork. Gifts with a fair-market value that exceeds $15,000 must be reported to the IRS on Form 709.
Unless you’re making a really big gift or have made really big gifts in previous years, there’s no gift tax due if you must file Form 709. That’s because US citizens have a $11.18 million lifetime exemption from gift tax. That’s twice what it was in 2017 ($5.49 million), before the Trump tax reform bill came into effect.
The exemption increases with inflation each year; the IRS recently announced the 2019 exemption will be $11.4 million. However, unless Congress acts before 2026 to make the higher exemption permanent, it will revert to $5.6 million (adjusted for inflation from 2018 through 2025).
Also, thanks to the tax reform bill, the estate tax exemption is $11.18 million. That’s no accident; the gift and estate tax exemptions are “unified.” Gifts you make valued over $15,000 per recipient (called “lifetime gifts”) erode the unified exemption dollar-for-dollar. For example, if you gift your granddaughter Vicky $16,000 this year, that gift will reduce your estate tax exemption from $11.18 million to $11.1799 million.
Lifetime gifts that exceed whatever exemption is in effect are subject to a gift tax of 40%, payable by the recipient. But otherwise, the recipient of a gift owes no tax on it. Similarly, estates larger than the unified exemption, less whatever lifetime gifts you’ve made, are subject to a 40% estate tax, payable by your estate after you die.
Gifts of assets that have gone up in value since you acquired them are especially tax-efficient for you as the donor. Once you make the gift, you transfer the responsibility to pay capital gains tax when it’s sold to the recipient. And if that’s someone much younger than you, such as a grandchild, that could be years or even decades from now.
Another tax-efficient gift is to pay the medical or educational expenses of a loved one. Such gifts aren’t subject to the $15,000 per recipient per year rule, and they don’t erode your unified exemption.
On the other hand, if your net worth is well under the unified exemption amounts, you might want to consider setting up what are called 529 plans for young people you care about. A 529 plan is like a Roth IRA for college. Like a Roth IRA, you don’t get a tax deduction for the funds you contribute to the plan. But the investments in a 529 plan accumulate on a tax-deferred basis and can be withdrawn tax-free to pay for college tuition.
But my all-time favorite gifting strategy is to make contributions to a young person’s Roth IRA. There are no age limitations; anyone can set up a Roth IRA if they have earned income. The contribution limit is $5,500 annually. You can make a contribution up to the amount of the young person’s earned income. And the young person can use the funds later for college or a down payment on a house.
For instance, if your son Joey earned $2,000 this year washing cars and mowing laws, he can contribute the entire amount to a Roth IRA. If he decides to use the money to buy a car, you could contribute up to $2,000 to his Roth. And so long as Congress doesn’t change the rules, the money both of you contribute to the Roth will grow tax-free for the rest of his life.
Naturally, Congress and the IRS have inserted some traps in the Tax Code that can trip up the unwary. The worst one is the so-called kiddie tax on passive income. If your dependent child under 19 (up to 24 in some cases) has income from sources such as stocks or bonds over a threshold amount ($2,100 annually in 2018), the income is taxed at a compressed rate with the top 37% rate coming into effect for an income of $12,501 or higher. In contrast, a married couple filing taxes jointly won’t hit the 37% tax bracket unless their income exceeds $600,000 per year.
The parent or guardian of the child must pay the kiddie tax. That’s true even if a grandparent, uncle, or other person who isn’t the child’s parent made the gift to which the income is attributable.
Fortunately, the lowest bracket of the kiddie tax is only 10% and applies to income above $2,100 up to $2,550. Thus, the kiddie tax on passive income of $4,650 would only be $255, or about 5.4%. To avoid the kiddie tax, it’s best to make gifts of passive assets that generate a relatively modest income.
There are many opportunities to make tax-efficient gifts to your loved ones during the holidays and beyond. What’s more, if you have an estate large enough to be concerned with gift and estate taxes, you can use numerous creative strategies to reduce this tax burden. We’ve covered many of them in the Nestmann Inner Circle Alert, a publication sent weekly to members of our Inner Circle Gold subscription service. To try out a no-risk subscription to the Inner Circle Gold, click here.
