By Financial Advisor Peter Egolf
Now that we understand how federal and state estate and inheritance taxes are imposed, let’s know one way of minimizing some of those taxes: gifting.
The Federal government allows you to gift your assets to anyone. Specifically, a certain amount of your gifts is exempted from federal gift tax each year.
The 2024 yearly gift tax exemption is $18,000 per person per beneficiary. For example, an elderly married couple could gift $36,000 to each of their adult children per year. This amount is adjusted yearly for inflation. They could give more than the yearly exempted amount, but that would count against their lifetime estate and gift tax exemptions of $13.61 million individually or $27.22 million as a married couple. As described earlier, these exemptions are may retreat to $5.49 million and $10.98 million, respectively, at the end of 2025. It’s important to remember that even if your assets are below the lower figures today, it’s pretty plausible that you may now exceed the limits with asset growth over the remainder of your life. Therefore, it might make sense to shelter those assets from federal estate taxation under the current elevated limits. Most Americans could gift all their assets and not touch their lifetime federal exemption, but they still need to consider state estate tax implications.
For example, if the couple above had an estate of $7 million in Vermont and were late in life, they could gift $2 million to their children in one year, using up the $18,000 current annual exemption and part of their lifetime exemption. While this would not impact their federal estate tax because they are under the current limits and haven’t used up their exemption, it would be impactful for Vermont's estate tax. They effectively reduced their estate by $2 million and down to the Vermont estate tax minimum of $5 million. Thus, they avoided having $2 million taxed at 16% or $320,000.
If the couple lived in Pennsylvania, they would have prevented tax on $2 million to the beneficiaries, which would be 4.5% or $90,000 if the heirs were solely their children. However, the other $5 million would still be open to inheritance tax, so they would want to explore additional ways of reducing their estate.
It’s important to note that most states do not impose a gift tax.1
While gifting can be helpful, gifting low-basis items, such as a house, is often counterproductive. For example, let’s say you purchased a home in Pennsylvania for $100,000 twenty years ago, now worth $1 million. You want to gift this house to your daughter because you don’t want her to pay a 4.5% inheritance tax when she receives this asset upon your passing. You could save her $45,000. Not so fast.
Taxable assets, such as a house or a brokerage account, step-up in basis at the time of death. Thus, your original basis of $100,000 becomes $1 million for your daughter. You have effectively eliminated $900,000 in capital gains that would be taxable at the federal and state level.
Let’s compare: You gift assets (saving $45,000 in Pennsylvania inheritance tax), but your daughter has to pay long-term capital gains (federal and state) on $900,000 when she sells the house ($900,000 x (15%+3.07%) = $162,630). Thus, the net tax to her is $117,630.
The alternative is to avoid gifting your house while you are alive and instead leaving it to your daughter through your estate/trust. The house cost basis is stepped up from $100,000 to $1 million at the time of your death. She will pay 4.5% of the house's value, $1 million , so $45,000 in Pennsylvania inheritance tax. And that’s it. If she sells the house immediately for $1 million, she pays 0% capital gains taxes. Thus, the net tax to her is $45,000.
By not gifting assets, you saved your daughter $72,630 in taxes!
Gifting your assets can be a powerful tool regardless of your wealth level. However, it’s essential to consider the whole tax picture to determine whether gifting is most appropriate for a given asset. As financial advisors, we work closely with our client’s estate and tax attorneys to execute a prudent estate plan.
Only two states, Connecticut and Minnesota, impose a state gift tax. Otherwise, you only need to worry about federal limits.
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