The Internal Revenue Service tracks nearly every form of income generated so it can collect the appropriate amount of taxes. As irritating as it may seem, it only makes sense that there is a federal gift tax regulating the transfer of assets from one person to another. However, it's important to note that gifts are not considered income, by definition. Gift tax is a separate tax that is imposed on the giver, not the recipient, and it is not the same as income tax.
But, if there is a nationwide tax on gifts, why don’t you have to report your birthday money each year? The reason for that is because your birthday gifts likely don’t exceed the gift tax limit. And if you’re lucky enough that they do, there are still several common ways to avoid paying the gift tax. In fact, many Americans avoid paying the tax throughout their lifetimes simply because of the allowed limits set by the IRS. However, there are certain instances where a gift tax may come into play. The following guide will provide more context on when the gift tax is required and walk you through the process of avoiding gift taxes where you can.
Lifetime gift tax exclusion
Before diving into the tips to avoid paying the gift tax, it is important to understand the Lifetime Gift Tax Exclusion. The Lifetime Gift Tax Exclusion is a credit that can be applied to the total value of gifts given during an individual's lifetime. In 2023, the lifetime gift tax exclusion is $12.92 million. This means that an individual can give gifts up to $12.92 million over their lifetime without owing any gift tax. It's important to note that this credit can also be used to reduce estate taxes at death.
6 Tips to Avoid Paying Tax on Gifts
Gifts of large amounts can occasionally be subject to the federal gift tax, but not in all cases. Read through the following tips for avoiding the gift tax:
1. Respect the annual gift tax limit
The best way to avoid paying the gift tax is to stay within the limit set by the IRS. So, what is the annual gift tax limit? In the 2023 tax year, the limit is set at $17,000 per recipient. Essentially, you can give $17,000 in gifts to as many individuals as you choose without being responsible for the gift tax. The moment you give over that amount to any recipient, however, the tax will be incurred. It's important to note that gifts under $17,000 are ignored for gift tax purposes, but over $17,000 requires you to file a gift tax return to show the use of the lifetime exclusion. Keeping it under $17k will mean no tax is owed as it is all excluded, but even if you exceed $17k, likely tax will not be owed. The $17k is still important though: under $17k is totally ignored. Over $17k will require you to file a gift tax return to show use of the lifetime exclusion. So staying under the annual exclusion is still optimal.
2. Take advantage of the lifetime gift tax exclusion
As mentioned earlier, the lifetime gift tax exclusion is $12.92 million in 2023. This means that you can give gifts up to $12.92 million over your lifetime without owing any gift tax. One penny over the exclusion makes it a taxable gift, but rarely will tax be owed. Additionally, it is important to note that this credit is effectively used to cover gifts during lifetime or estate tax at death. So if I use $5 million of that to shield lifetime gifts, then I have $5 million less credit to cover against estate tax when I die. This is a “unified” credit to cover gifts and/or estate tax.
3. Spread a gift out between years
Another way to avoid the gift tax is to spread a gift out between years, making sure to avoid exceeding $17,000 in one tax year. This strategy can help you maximize the amount you give, but by spreading it out over time you can reduce the overall taxes owed on your present.
Let’s say Sarah wants to give her niece, Lisa, a gift of $25,000. To avoid paying the gift tax, Sarah could give Lisa $12,500 for her birthday in 2021. Sarah could then wait until 2022 to give the remaining $12,500 on Lisa’s next birthday and avoid paying the gift tax altogether.
4. Leverage marriage in giving gifts
Surprisingly enough, married couples are treated independently when it comes to the gift tax limit. What this means is that the gifts one spouse donates or receives will be classified separately from the other spouse, regardless of whether or not the couple files taxes jointly.
The parameters of this exclusion are twofold. First, you and your spouse can both provide gifts of up to $17,000 per recipient in one year (as long as the gifts are from joint property). This essentially allows married couples to give up to $34,000 per recipient each year.
The second way to leverage this rule is by gifting to married couples. You can donate up to $15,000 per spouse, without exceeding the annual gift tax limit. As mentioned above, spouses are treated differently in terms of the annual limit -- regardless of how many assets are combined or shared.
Looking at a somewhat extreme example, you and your spouse could give up to $68,000 to another married couple without exceeding the gift tax limit. Let’s say you gift $17,000 to your friend and then another $17,000 to their spouse; your own spouse can then give up to $17,000 to your friend and their spouse in addition to your gift.
5. Provide a gift directly for medical expenses
One of the most notable exceptions to the gift tax limit is money designated specifically for medical expenses. However, the gift must be paid directly to the medical institution or insurance provider. Gifts made directly to the recipient with the purpose of covering medical costs will still be subject to the gift tax limit.
For example, if you wanted to cover the costs for your grandparent to stay in a nursing home, you would need to work directly with the organization on billing. This would allow you to regularly pay for the medical costs, without worrying about exceeding the annual gift limit.
6. Provide a gift directly for education expenses
Similarly to medical expenses, educational gifts can also avoid the gift tax limit when they are paid directly to an institution. Money can be gifted for tuition costs and other qualifying expenses as long as the donor pays the school or university and not the student. Unfortunately, gifts made to cover books or supplies do not count towards the education exclusion and instead will go towards the annual gift limit.
7. Consider gifting appreciated assets
Gifting appreciated assets, such as stocks or real estate, can be an effective way to avoid paying the gift tax. When gifting appreciated assets, the gift tax is based on the asset's fair market value at the time of the gift rather than its original purchase price. So, if you bought a stock for $10,000 and it's now worth $20,000, you can gift the stock to someone and pay gift taxes on the $20,000 value, rather than the original $10,000 purchase price.
It's important to note that when inherited, appreciated assets get a "step up" in basis, meaning the basis of the asset is reset to the fair market value at the time of inheritance, which can result in a lower capital gains tax when the assets are eventually sold. However, it's important to keep in mind that tax planning can be complicated, and it's always a good idea to consult a tax professional to ensure that you are taking advantage of all available tax benefits and minimizing your tax liability.
In summary: how to gift money without paying tax
The gift tax is discussed much less frequently when compared to other common taxes, such as income or sales tax. This is because there are so many exclusions. Many individuals avoid paying gift taxes altogether in their lifetime, simply by following the above tips.
While it is somewhat uncommon to encounter the gift tax, given the exclusions and limits, there are situations where this cost may seem unavoidable. If you are curious about how to give money or high-value assets to your loved ones, consider a tax-forward estate planning strategy. This can allow you to specify certain gifts for your family and friends and minimize the amounts deducted for taxes.
The gift tax is an interesting regulation given its many exclusions and limits. Gifts can be made up to $17,000, while seemingly unlimited amounts can be contributed towards educational and medical costs. However, the gift tax is not to be underestimated -- particularly when it comes to long-term financial planning. Review the above tips on avoiding the gift tax and consider how it might impact your estate planning.
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