December is a traditional season of giving. Making lifetime gifts, even taxable gifts, is often the simplest, most tax-effective and least expensive way to pass wealth down to younger generations and reduce or avoid estate tax. This year, generous donors have a special strategic opportunity to make taxable gifts to family members, charities, or other deserving beneficiaries. However, some of these tax-saving opportunities are available only during 2010.
What follows is a list of the top reasons to consider making gifts in 2010.
- 2010 ONLY: The federal gift tax rate is historically low at only 35 percent. The federal gift tax applies to all lifetime gifts you make in excess of your $1,000,000 lifetime gift exemption and $13,000 per beneficiary annual gift exclusions (described in greater detail below). For 2010 only, the gift tax rate is 35 percent. Gift tax rates have not been this low in 75 years. In 2011, the tax rate is scheduled to skyrocket to 55 percent. For example, a $100,000 taxable gift at 2010 tax rates costs only $135,000 ($100,000, plus 35 percent gift tax on $100,000). Under the upcoming 55-percent tax rate, holding the same $135,000 until death results in only $60,750 passing to your beneficiary ($60,750, plus 55-percent tax on $135,000), which is a nearly 40-percent reduction in the resulting gift. (This calculation assumes that you survive at least three years after you pay the gift tax, as explained in greater detail below).
- 2010 ONLY: No generation-skipping transfer (GST) tax. Taxable gifts to grandchildren or other beneficiaries two or more generations younger, in excess of your GST exemption ($1,000,000 indexed for inflation since 1997), are generally subject to GST tax in addition to gift tax. For 2010 only, there is no GST tax on these gifts. This means that, in 2010, you can pass an unlimited amount without paying any GST tax. In 2011, the GST tax is scheduled to return to a rate of 55 percent. As shown above, a $100,000 taxable gift to a grandchild in 2010 will cost $135,000 ($100,000, plus 35-percent gift tax on $100,000). However, in 2011, the same transfer of $135,000 for the benefit of a grandchild in excess of your GST exemption will pass only $43,549 to the grandchild net of taxes ($43,549, plus 55-percent GST tax on $43,549, plus 55-percent gift tax on $67,500), which is a reduction of more than 56 percent. Even worse, holding the same $135,000 until death and then transferring it for the benefit of a grandchild will result in only $39,194 passing to that grandchild ($39,194, plus 55-percent GST tax on $39,194, plus 55-percent estate tax on the entire $135,000), which is a reduction of more than 60 percent. While it remains a remote possibility that Congress may impose a GST tax retroactively on 2010 gifts, we can employ gifting techniques designed to avoid the tax risks of that unlikely event.
- You can give $13,000 tax-free every year. Each year, you may make tax-free gifts to each of your beneficiaries of up to the federal annual gift exclusion amount. In 2010 as well as 2011, the annual exclusion is $13,000. Married couples can combine their gifts to give up to $26,000 to each beneficiary each year. Do any of your beneficiaries have college in their future? You can take advantage of special Section 529 College Savings Plan rules and prepay up to four additional years of contributions. Thus, a couple can give $130,000 to each beneficiary's 529 plan this year tax-free. In addition, some states allow income tax deductions for such contributions.
- Direct payment of medical expenses and educational tuition are tax free every year. Transfers (of any amount) on behalf of someone else, either directly to a medical institution or professional that provided care for that person, or directly to a qualifying educational institution for tuition or training of that person, are not considered to be gifts for federal gift tax purposes and are not subject to the annual or lifetime exclusions.
- Make $1,000,000 in lifetime taxable gifts without paying any tax. In addition to the $13,000 tax-free gifts you may make to each beneficiary each year, you may use your lifetime gift exemption to make further tax-free gifts up to $1,000,000 during your lifetime. The $1,000,000 lifetime gift exemption amount has remained unchanged since 2002 and is not scheduled to increase in future years.
- Lifetime gifting removes future appreciation from your estate. Not only are the gifted assets removed from your taxable estate, but any subsequent income and appreciation on the assets are as well. A $1,013,000 asset appreciating at eight percent per year will be worth more than $2 million after nine years and nearly $3 million after 14 years. If you make such a gift in 2010 and use your gift tax lifetime exemption, you would pay no gift tax on the underlying asset or any future appreciation. However, under the tax laws in place for future years, retaining the appreciated asset and transferring it through your estate will cost nearly $350,000 in estate tax after nine years, and more than $750,000 in estate tax after 14 years. Consequently, instead of passing 100 percent of the asset out of your estate by making a lifetime gift now, you would transfer only 83 percent of the appreciated asset after nine years and only 75 percent after 14 years.
- Hidden benefit of paying gift tax. The gift tax is imposed only on the taxable gifts that you make — it is not imposed on the amount you pay in gift taxes (assuming you survive at least three years after paying the gift tax). In contrast, the estate tax is imposed on both the amount you pass to your beneficiaries and the amount you pay in estate taxes. Consequently, if you have a taxable estate, you pay a higher effective tax rate on taxable transfers at death than during life (assuming you survive three years after paying the gift tax), even when the gift tax and estate tax rates are equal. For example, in 2011 it will likely cost you $155,000 to make a lifetime taxable gift of $100,000 when the gift tax rate is 55 percent ($100,000, plus 55-percent tax on $100,000). If, instead, that same $155,000 passes through your estate when the estate tax is 55 percent, only $69,750 would transfer to your beneficiary ($69,750, plus 55-percent tax on $155,000), which is a reduction of more than 30 percent. Note that in 2010, gift tax rates are only 35 percent compared to the 55-percent rates scheduled for 2011, making 2010 an even better year for gift giving!
Only a few weeks remain to take advantage of your 2010 annual gift tax exclusion, historically low gift tax rates, and unlimited tax-free generation-skipping transfers. The estate tax is unlikely to be repealed in the foreseeable future given the federal fiscal outlook.