Who would ever want to pay a gift tax if they did not have to?
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.
- A $5.34 million exemption from any taxable gifts.
- An exemption from taxable gifts of $14,000 of money or other assets per person per year.
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 $14,000. 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 $14,000. So $46,000 out of the $60,000 gift is a taxable gift.
Do you have to pay a gift tax?
No, because you have a $5.34 million dollar gift tax exemption and you have just used up $46,000 of it, leaving you with a remaining exemption of $5,294,000. Only once you have fully utilized your $5.34 million gift tax exemption do you actually have to pay a gift tax. Once you do fully utilize it, then any further taxable gift will be taxed at a flat 40% gift tax.
Connecticut is the only state with a gift tax
Connecticut, the only state with a gift tax, has a similar scheme. The Connecticut gift tax exemption however is smaller: $2.0 million—but so are the gift tax brackets which range from 7.2% to 12%.
By the way, both the IRS and Connecticut also have an estate tax too. There is an estate tax exemption too of the above $5.34 and $2.0 million dollars BUT you only get one exemption, meaning that if you make lots of large gifts, like the one discussed below, and you fully your gift tax exemption, you will not have an exemption left to protect your remaining assets from estate taxes when you die.
Payment of an actual gift tax
Let’s assume that you have fully utilized, because you are both wealthy and generous, your $5.34 million gift tax exemption AND that you already gave your child $14,000 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 hold onto the $224,000 when you die, and then pay estate tax on it, or
2) if you are willing to part with it, you can give it away now.
Here’s an example
Let’s look at those two options closely.
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 will have $618,000 in your estate and, at a 40% estate tax rate will 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, remember, to part with $224,000. So 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!