The greatest country on the planet has a serious problem when our tax regulatory agency…
Repetition is the key to memorization, so let’s repeat that headline: “Gifts to Children are not income taxable.” The annual gift limit (which in 2022 is $16,000) has nothing to do with income taxation. To repeat, the annual gift limit has nothing to do with income taxation. In over 40 years of my career, this is undoubtedly the most commonly mistaken assumption by the public on personal finances. I have written about it and spoken about it, but inevitably clients call and ask, “If I want to give my kids $100,000 to buy a house, how much will that cost them in taxes?” The answer is nothing! Children do not pay income taxes on a gift.
Logically, you may be wondering, “Then what is the $15,000 (now $16,000) annual gift tax limit?” It relates to a lesser understood tax system called the Estate and Gift Tax laws. Estate and Gift taxes have to do with the combined amount you can transfer to non-spouses in your lifetime and at death. That limit in 2022 is $12,060,000 due to the Trump tax law of 2017, which doubled the lifetime amount. This expires on December 31, 2025, with the current exemption to be halved starting January 1, 2026 back to around $6.5 million, adjusted to inflation.
In my opinion, the estate tax is one of the top five cruelest forms of taxation. In essence, it says in your lifetime and at death the maximum you could give your family is $6.5 million after the year 2025. Any amount that is calculated above this maximum is taxed at a rate of 40%. Believe it or not, the exemption in 2001 was only $675,000 with a 55% tax rate, and so we have seen tremendous improvement. The estate tax was initially established to prevent a single family in America, like Rockefeller or Getty, from dominating most of the wealth. As with all taxation, politicians crave more financial resources, and they have allowed the scope of the tax to expand to impact the finances of average American households. Senator Sanders believes the estate exemption should be $3.5 million with a 45% tax rate. The belief underpinning the estate tax is that children did not earn these funds, and only a small percent of Americans have this much to give their children; why should these winners of the DNA lottery be afforded such a windfall? Proponents ask that we think of the good that government can do with the tax revenue.
Therefore, every American with a million dollars or more of wealth should work with an advisor that solidly understands the tax laws. Making a mistake with gift and estate taxes can be most costly, with a minimum tax rate of 40% of the estate exceeding the limit. I have not even mentioned that some states (such as NY, MD, CT, IL, OR, WA, MN, MA, RI and DC) have an additional state estate tax, some with limits as low as $1 million. The reason the estate tax is so cruel is that people of financial sophistication and vast wealth merely hire people to figure this out and bypass much of the taxation using expert planning techniques. Many families with an estate of $1 million or even up to $25 million may not have the sophistication or the expertise to maneuver around the taxation, and the family only learns of the consequences after a death. The result is that in 2016, estates of $10 million or less filed 57% of the taxable estate tax returns.
So how do the Estate and Gift Tax laws work, and what is the significance of the $16,000 gift exclusion (which, again, has nothing to do with income taxes)? A husband and wife can transfer unlimited amounts of money to one another as lifetime gifts or upon death. Prior to 1982, this was not true, and even a spouse could have paid estate taxes. The 1981 Estate exclusion was only $175,000 with a 70% tax. I saw the devastation of a widow in 1980 whose husband died having an illiquid estate of $650,000 in real estate deals and no estate tax planning strategies in place. Can you imagine a widow dealing with grief and financial hardship due to these laws? In 1982, Reagan passed the unlimited marital deduction allowing spouses to pass any amount to one another without taxation during lifetime or death. The total amount you can give everyone else is $6.5 million beginning in 2026. So, am I reducing my lifetime exclusion every time I give my children a birthday gift of a $100? This is where government benevolently gave us the annual gift tax exclusion rule. You can give up to $16,000 annually to as many people as you desire without reducing your $6,500,000 Gift and Estate Tax exclusion. Yes, each gift for birthdays and Christmas are counted in the annual $16,000 exclusion.
There are two gifts that do not impact the $16,000/year exclusion: college and medical expenses. Many times a parent will spend large sums of money on the education and health of their children, and it has been decided that these expenses over the annual exclusion should not reduce the lifetime exclusion. The $16,000 per year exclusion is also per person. If a husband and wife have three married children, how much can they give each child? The husband can give $16,000, and the wife can give $16,000, to each child and to each in-law if they desire. That is $32,000 to each child for a total of $96,000 to all three; if they give the in-laws $32,000 each, it’s another $96,000 for a total of $192,000 annually with no reduction to either the husband or wife’s lifetime exclusion of $6.5 million. (To repeat again: gifting to children has nothing to do with income taxes and is only applicable to the Gift and Estate Tax laws.) The $6.5 million Gift and Estate Exclusion is available to both the husband and the wife for a family total lifetime exclusion of $13 million if executed properly. Large estates are almost always going to get this right, but a small estate can easily fall prey to these obscure and complicated Gift and Estate Tax laws.
What happens if I give my three children over $16,000 in one year? Assume the above couple gave their three children $100,000 each, specifically excluding the in-laws. Since a husband and wife can give the children a total of $32,000, $100,000 is $68,000 greater than the exclusion. Thus, the husband and wife both gave $34,000 in excess of the annual exclusion to each child. Three children multiplied by $34,000 means each parent will file a gift tax return and reduce their $6.5 million lifetime exclusion by $102,000. After these gifts of $100,000 per child by mom and dad, each parent is left with a $6,398,000 lifetime and death exclusion rather than $6.5 million. Note that neither the children nor the parents actually had any monetary tax payments due, only a filing requirement to note the lifetime exclusion reduction. As a matter of fact, it is only the giver that is ever impacted by a gift received, with no requirements of the recipient. The recipient – your child – has no requirements on their part, no matter how much they receive. Only the giver (the parent) deals with the requirements and the potential taxation of the Gift and Estate Tax laws. The Gift and Estate Tax laws apply to the transfer of assets, not the receipt of assets. The government wants to make sure you do not give more than the $6.5 million (beginning 2026) or $12,060,000 (currently) combined in your lifetime and death.
In conclusion, gifts have nothing to do with income taxation, and the annual exclusion of $16,000 per person per year is applicable only to the obscure Gift and Estate Tax laws, and then only to the giver. If your net worth is over $3 million, it is imperative that you have a financial advisor who is a tax expert to make sure you properly assess all planning techniques necessary to keep your family aware of a tax that is paid mostly by the unsuspecting.
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