Legacy Planning: Introduction to the Gift Tax and Generation-Skipping Tax
Author: Jonathan Harrington
When you offer gifts to anyone other than your spouse, federal gift tax rules may come into play. However, this seldom leads to any tax payments. In this blog post, we will discuss the yearly gift tax exclusion, how the gift tax and estate tax work together, and the generation-skipping tax as it applies to gifts made to irrevocable trusts.
The Yearly Gift Tax Exclusion
For 2023, you can give gifts of up to $17,000 per recipient without any tax consequences. This means you could provide $17,000 each year to each of your children or grandchildren without ever paying any tax or needing to file a gift tax return. This annual exclusion amount is occasionally adjusted for inflation.
If you exceed $17,000 in gifts to a single person, you are required to file a gift tax return with the IRS for that year.
How the Gift Tax and Estate Tax Work Together
Filing a gift tax return does not automatically mean that you pay any gift tax. Any gifts over $17,000 simply reduce your lifetime gift and estate tax exemption.
In 2023, this lifetime exemption is $12.92 million for each individual. This means that if you pass away with assets valued at greater than $12.92 million, your estate will owe taxes on the amount exceeding the exemption.
Let's look at a couple of examples:
Example 1: You pass away with $13.5 million worth of assets and never gave any gifts that were over the annual exclusion. This means your estate owes taxes on $580,000 – the difference between your total assets and the lifetime exemption.
Example 2: You pass away with $12.5 million of assets, but in the year before you died, you gifted your child $1,017,000. Since this amount exceeds the $17,000 annual exclusion by $1,000,000, your lifetime exemption is reduced by $1,000,000. Your lifetime exemption is now $11.92 million, and your estate owes taxes on $580,000 at the time of your death.
Contributions to 529 Plans
Contributions to a custodial/UTMA account or a 529 college savings account are considered gifts to the child who either owns the custodial account or is the beneficiary of the 529 account. So any contributions over $17,000 will reduce your lifetime exemption, and you will need to file a gift tax return.
One exception to this rule is the ability to "superfund" a 529 plan. The IRS allows you to contribute a lump sum of up to five times the annual exclusion ($85,000 for 2023) to a 529 plan in a single year. The gift is considered as having been made evenly over five years and does not reduce your lifetime exemption. But if you do contribute the full $85,000 allowed, you cannot make any additional gifts to that child until the five-year period has ended. Additionally, you must file a gift tax return in the year the gift is made.
It's important to note that tuition paid directly to an educational institution on a child's behalf is not considered a gift. This applies only to tuition and not to room and board, books, or supplies.
Gifts to Trusts
You might think that you can also make gifts up to $17,000 per person per year into an irrevocable trust where that person is a beneficiary. However, the beneficiary must have a "present interest" for the gift to qualify for the exemption. Specific language must be included in the trust document to meet this rule. Otherwise, the gift will reduce your lifetime exclusion.
Generation Skipping Tax
The generation-skipping tax is an additional tax that applies when you make gifts to beneficiaries who are two or more generations below you or more than 37.5 years younger than you, such as your grandchildren or great-grandchildren. This tax is meant to prevent wealthy individuals from avoiding estate taxes by transferring assets directly to younger generations.
Like the gift tax, everyone currently receives a $12.92 million exemption from the generation-skipping tax, as well as a $17,000 per-year per-person exemption. When filing a gift tax return, it is essential to consider the generation-skipping tax implications, as the exemptions and rules differ slightly from the gift tax rules.
Gifts to Irrevocable Trusts and Generation-Skipping Tax
When you make gifts to irrevocable trusts, the generation-skipping tax may apply if the trust beneficiaries are considered more than one generation younger than you. To avoid the tax, the trust must be structured to comply with specific generation-skipping tax rules.
One strategy to avoid the generation-skipping tax is to establish a "dynasty trust" designed to last for multiple generations. With proper planning, assets in a dynasty trust can be transferred to future generations without incurring generation-skipping taxes. However, this strategy requires careful legal and tax planning to ensure compliance with complex tax rules.
For most people, the gift tax rules will never result in any actual tax being paid. However, it is crucial to be aware of the annual exclusion limits and how the generation-skipping tax may affect gifts to irrevocable trusts, so you can accurately report any gifts that will reduce your lifetime exemption. By understanding these tax implications, you can make more informed decisions when it comes to gifting and estate planning.
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Disclaimer/Author(s) Bio: This is not to be considered investment, tax, or financial advice. Please review your personal situation with your tax and/or financial advisor. Jonathan Harrington, CFP®, MSFP, MST is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford, NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.