Gifting-During-Life Strategy: Does It Make Sense for YOUR Family?

By Jeffery Levine, IRA Technical Expert  

Follow Me on Twitter: @IRAGuru4EdSlott

When it comes to estate planning, one of the primary goals is to transfer as much of a person’s assets to their intended beneficiaries at the lowest cost or, in other words, by paying the least amount of tax. Today, the federal estate tax exemption is $5,340,000 per person. It is also portable (can be transferred) between spouses, giving them a maximum exemption of $10,680,000 per couple and the maximum rate is 40%. That is a far cry from where we’ve been. In the not-too-distant past, the federal exemption was at $1 million, it wasn’t portable and the top rate was 50%.

Due to the massive amount of assets that could have been lost to federal estate tax, people looked for any way to avoid it. Oftentimes, that included gifting away assets during life which, while providing an estate tax edge, probably wasn’t the better move when it came to the income tax side of things. As a result, in order to maximize the value of one’s estate, a careful analysis of estate tax costs vs. income tax costs was necessary.

Today, with the more favorable estate tax laws, most people don’t have this problem… at least at the federal level. As a result, it’s usually more tax efficient for people to hold onto their assets until death than to gift them earlier in life. Some states, however, still impose a state estate tax at much lower levels, making gifting during life still a potentially viable tax efficient strategy. While every situation should be evaluated on its own merits, here are a few points to consider when evaluating if a gifting-during-life strategy is right for you and your family.

Upside – No state gift tax (probably)
Chances are you live in a state with no state gift tax. In fact, at last count, there were only two states in the entire country that imposed a gift tax at the state level… Connecticut and Minnesota, with the latter enacted only recently. On the other hand, there are quite a few states that impose a state estate and/or state inheritance tax. In such cases, giving away money during life could save you tax.

Example: Bill lives in New York, which does not impose a gift tax at the state level but currently has a $1 million state estate tax exemption. Suppose Bill has a $2.5 million estate. He is currently well below the federal estate/gift tax exemption, but, if he were to die today, he would be $1.5 million over the New York state estate tax exemption. This would cost his heirs well over $100,000 in state estate taxes.

Now imagine that Bill decides to gift $1.5 million to his children today. There is no NY gift tax assessed because NY does not have one. Furthermore, after the gift, Bill is left with an estate of $1 million. When he passes away, assuming his estate hasn’t further increased, he can leave the entire amount state estate tax free to his children using his $1 million NY state estate tax exemption.

Downside – No step-up in basis
This is oftentimes the biggest drawback of gifting assets. Under the current law, capital assets get what’s known as a “step-up in basis” after the death of their owner. Under this rule, a beneficiary generally gets to use the value of the property on the owner’s date of death as their new cost basis, which can save money in capital gains tax when the assets are later sold. When, on the other hand, assets are gifted, the recipient generally uses the owner’s cost basis to determine any capital gains tax.

Example: John has an estate worth $1.4 million. Most of his estate is made up of stock of a company, Company X, John bought years ago for $100,000. Over the years, the value of that stock has risen dramatically and is now worth $800,000 (so the remainder of his estate is worth $600,000. If John gifts all of his Company X shares to his daughter, they will be removed from his estate, which could help save him state estate tax, depending on where he lives. If his daughter were to turn around and sell that stock, however, she would have to pay capital gains on the $700,000 of gain. Between the top federal capital gains rate of 20%, the 3.8% healthcare surtax and any state income tax that might apply, John’s daughter could end up paying more than $175,000 of tax on the gain.

Conversely, now imagine John holds his shares of Stock X until he dies. With the value of the shares still in his estate, John may be subject to a state estate tax, but – and this is a big but – his daughter can now use the value of those shares on his date of death as her new basis. So, if John’s daughter turns around and sells her inherited shares of Stock X the very next day, she gets to use the $800,000 date-of-death value as her cost and she will owe no tax on the sale. She gets to keep every penny.

There are other factors to consider when looking to gift assets. They include:

Downside – You can’t take it back
No backsies! At least not when it comes to the tax law. A completed gift is generally not something that can be undone. So, quite simply, make sure you don’t need or want an asset before you give it away.

Upside – Future income/appreciation is outside of your estate
Suppose you own a stock that’s worth $10 and pays a dividend of $1/year. That dividend is taxable to you and adds to your estate. Plus any appreciation on the stock also is in your estate. If you gift the stock to your adult child, any future appreciation on that stock, as well as the dividends, will increase your child’s estate, not yours.

Downside – Not all assets can be gifted
Not everything you own can be gifted to a child or other beneficiary. IRAs and other retirement accounts are probably the greatest example of this. Outside a divorce settlement, which doesn’t really count, there is absolutely nothing you can do to give your IRA to someone else during your life. The only way you can transfer those funds to another person is to take a distribution, pay the tax on it, and give the proceeds to another person. By that time, though, it’s no longer and IRA and you’ve probably created a tax nightmare for yourself.