All About the Gift and Estate Tax

By Zeke Anders on July 25, 2023

Many people want to leave an inheritance for their children, grandchildren, and cherished causes. Those that do often worry that the inheritance will be taxed and their heirs will only get a fraction of the assets. In this piece, we’ll explain the Gift and Estate Tax and some ways to plan for them.

The Gift Tax and Estate Tax are two sides of the same coin. The Gift Tax applies to gifts while you are living, and the Estate Tax applies to bequests when you pass away. There is a lifetime exemption amount that applies to both taxes. The exemption amount for 2023 is $12,920,000 per person, so a married couple has total exemptions of $25,840,000. The limit is adjusted for inflation annually. Assets that you give away during your lifetime will reduce this exemption amount for the rest of your life and at your death. For example, if you gave away $1,000,000 during your life, your remaining estate tax exemption would be $11,920,000. The current limit was set by the Tax Cuts and Jobs Act of 2017.

Obviously, with an exemption amount this high, the gift and estate tax will not be an issue for most families. However, if Congress does not take action, at the end of 2025 the exemption amount will revert to its 2017 level (about half of the current level), adjusted for inflation. In other words, the exemption amount will drop to roughly $6.5 million per person if Congress doesn’t act. An important aside is that just because you may not have an estate tax issue does NOT mean you do not need a solid estate plan. An estate plan is important regardless of how big your potential estate is, and it is beneficial to talk to an estate planning attorney to ensure you have the proper documents in place and that they accomplish your legacy goals.

Any assets that you transfer over the exemption amount will generally be taxed at 40% of their value. Unlike income tax, you are not just taxed on the gains, but on the value of the asset. This can create issues for those with substantial illiquid assets like real estate, land, or a closely held business. There’s also another tax called the Generation-Skipping Tax (GST). If you thought to yourself, “well, I’ll just leave everything to my grandchildren so my assets aren’t taxed again when me kids are gone,” the Generation Skipping Tax (GST) comes into play. The GST is levied on assets that are transferred to a non-spouse who is 37 ½ years younger than the donor. Again, there’s a lifetime exemption amount which mirrors the Gift and Estate Tax exemption amount. Above that exemption, there’s an additional 40% tax. Paying two 40% taxes on the value of the assets you leave to your heirs could dramatically reduce the assets they actually receive. Luckily, there are some strategies you can use to mitigate the Gift and Estate Tax. We’ll discuss some simple strategies, but again, it is worthwhile to talk to an estate planning attorney who may suggest additional strategies.

There is an annual exclusion amount of $17,000 per donor per beneficiary in 2023. Any gifts under this exclusion amount do not count towards your lifetime exemption amount. A married couple can split gifts, and give $34,000 to any given beneficiary, to as many beneficiaries as they want. For example, if you have 6 grandchildren you could give, as a couple, $34,000 to each for a total of $204,000 which is excluded from your lifetime exemption amount. To go even farther, if you have 3 children, all of whom are married, with 2 children per couple, you could give $408,000 between the children, their spouses, and all the grandchildren. Doing so annually can gradually reduce your taxable estate. 529 accounts provide another opportunity to supercharge these gifts. 529 plans allow you to accelerate 5 years of gifting into one year. In other words, an individual could gift $85,000 to a 529 plan for each beneficiary, and a couple could give $170,000. There are two catches with this approach. If you give the full five-year amount in one year, you can’t give any more gifts to those grandchildren for the rest of the period. Additionally, if you die within the 5 years, some of the gifts may be included in your estate again. However, this can get a substantial amount of assets out of your estate without using the lifetime exemption amount.

There are some types of transfers that are exempt with no limit. There is an unlimited marital deduction, for example. Gifts or bequests left to your spouse are not taxable. Additionally, gifts to charitable organizations are exempt. This could include churches, non-profit hospitals, universities, or donor advised-funds and private foundations. Leaving an asset such as a Traditional IRA, where all distributions will be taxable to your heirs, to a charitable organization or private foundation which will not owe much if any income tax can be an efficient legacy strategy. Additionally, payments made directly to a medical or educational institution may be exempt from gift and estate tax.

Another strategy is to use up your lifetime exemption amount as early as possible. If you are in a position to transfer assets early, those assets can grow outside of your estate. Ideally, you can use up the GST exemption amount and the gift tax exemption amount to reduce estate tax for yourself and the next generation. By spending down the remaining assets in your taxable estate, you reduce the amount that is taxable. The main benefit of this approach is that it “freezes” the value of the assets you transfer. Planning for the estate tax can be difficult because future growth rates are unknowable. Over time, your taxable estate may continue to grow, and so will your estate tax burden. By transferring assets out of your estate earlier, the future growth is may not be subject to estate tax. But this strategy must be balanced with leaving assets in your estate to fund your lifestyle, as well as understanding the tradeoffs around control of the assets. This strategy becomes popular when Congress threatens to reduce the exemption amount, as they did in 2020, and there may be a flurry of estate planning activity in 2025 as the exemption amount is scheduled to be reduced. Waiting to plan until the deadline may run into busy attorneys and CPAs and runs the risk of not completing transfers in time. For non-marketable assets, valuations may be required which can take time. It may be better to start this process sooner rather than later.

Lastly, life insurance can provide liquidity to the estate and replace assets lost to estate taxes. When a life insurance policy is owned by an irrevocable trust, the proceeds may be kept outside of your taxable estate, and life insurance proceeds are generally income tax free. As we mentioned earlier, illiquid assets such as real estate, land, and closely held businesses can lead to estate tax burdens without liquidity to cover them. Without proper liquidity planning, heirs sometimes must sell cherished family assets in a fire sale to pay estate taxes. Life insurance can provide liquidity the moment it is needed and may not be subject to market volatility. There are more strategies that may be helpful for this situation, life insurance is just one.

A strategy to mitigate the estate tax may not be the optimal strategy from an income tax perspective. Trusts have much more compressed tax brackets, meaning the effective income tax rate on a trust will generally be higher than for a natural person. That said, your estate planning team should work together to find the best approach for your goals and desires, balancing asset protection, utility, and taxation. Your heirs may not appreciate all the money you saved on taxes if the assets are completely unavailable to them, or alternatively if the assets are too easily available to someone who can’t manage them responsibly. While we’ve gone in-depth on taxation in this piece, the most important thing in estate planning is to determine what you want to accomplish for yourself and for your legacy. Once you know what you want to accomplish, a strategy can be built to maximize the odds of achieving your goals. 

Zeke Anders – Planning Specialist | zanders@twickenhamadvisors.com

Disclaimer

Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.