The answer: Your children!
Let’s take a closer look at this and let me give you some background.
The IRS has a gift tax. If you are a very generous person who makes lots of big gifts, you may have to pay a tax while you are alive, for the privilege of making that gift. But there are two protections against the tax.
- As of the 2021, the IRS has a $11.70 million lifetime federal exemption from any taxable gifts.
- There is also an annual exemption from taxable gifts of $15,000, per person and per gift recipient.
How do these interplay? Let’s say you give your child $10,000 to help pay off a credit card. That is a gift.
Is it a taxable gift?
No, because it is less than $15,000. End of story.
But let’s say you give your child $60,000 to help pay off their mortgage.
That is a gift. Is it a taxable gift?
Yes, but only to the extent that it exceeds $15,000. So $45,000 out of the $60,000 gift is a taxable gift.
Do you have to pay a gift tax?
No, because you have that federal lifetime exemption described above. In the above example, you would have only used up $45,000 worth of your respective state and federal exemptions, meaning you could make an additional $11,655,000 before you would have a federal gift tax liability. If you do end up exceeding that lifetime limit, any further gifts would be taxed at a flat 40% level.
Connecticut is the only state with a gift tax
Connecticut, the only state with a gift tax, has a similar scheme. It operates exactly the same way as the federal one except in 2021 Connecticut’s lifetime exemption amount is a bit smaller at $7.1 million. And the gift tax brackets are a bit smaller too, ranging from 7.2% to 12%.
By the way, both the IRS and Connecticut also have an estate tax too. And in each case your estate tax exemption is the same as your lifetime cumulative gift tax exemption. So although they are two different tax mechanisms, they are tied together. Thus, if you made taxable gifts during your lifetime and you filed the necessary gift tax returns, those amounts get rolled into your estate tax return filing after you pass.
Payment of an actual gift tax
Let’s assume that you have fully utilized, because you are both wealthy and generous, your $11.70 million federal gift tax exemption AND that you already gave your child $15,000 this year. And yet you want to make another gift knowing, that if you do, you will now have to pay a federal gift tax of 40% of the amount of the gift.
Let’s also assume that you don’t really need that amount of “extra” money for your foreseeable future.
You have two choices:
1) you can forgo making that gift, holding onto that money until you die, and then your loves ones will end up paying estate tax on that amount, or
2) if you are willing to part with it, you can give it away now, but then you must pay a gift tax now, prior to your death.
Here’s an example
Let’s look at those two options closely. For example, suppose you’ve got $224,000 you are thinking of gifting.
If you hold onto the $224,000 and live, say 15 years and your $224,000 grows at 7% each year, then, when you die you will have $618,000 in your estate and, at a 40% estate tax rate your executor will have to pay $247,000 in federal estate taxes. This leaves the children with $371,000.
What if, instead of holding onto the money, you parted with it – but you are only willing to part with $224,000. You give your children $160,000 now and INTENTIONALLY incur and pay a gift tax NOW of $64,000, thereby parting with a total of $224,000.
If you assume (so we can compare apples with apples) that the children then invest the gifted money for 15 years at 7%, they will have, when you die after 15 years, $441,000. If you were them, would you rather have $441,000 or $371,000 in 15 years?
There you have it. A case where paying Uncle Sam may benefit you!