We have a lot of generous clients! As financial advisors, we often hear that our clients would like to share some of their wealth with the people they love. The team at Birchwood has previously touched on questions to ask before gifting and what to consider if financially helping young adult children. This article will tackle the one question we almost always hear, “Will I or my family member have to pay tax if I give them money?”
The short answer is: Probably not. But to avoid paying taxes on a gift, you need to give the right way. In this article, I will cover monetary gifts during life and after death and touch on proposed tax law changes.
During Life
Some of our clients tell us that they enjoy gifting to their families while alive because they witness the joy and relief that their kids might experience. It could be a gift that allows your kids to go on a much-needed vacation or funds to help during one of life’s tough spots. Either way, many clients don’t want to wait until they have passed away to share some of their wealth.
Annual Gift Tax Exclusion
The gift tax exclusion is an amount any one person can give to any other person in a year, and neither one has to pay taxes nor file any forms. The number changes from time to time and is currently $15,000. Note that if you are married and have a child, each of you can give $15,000 to that child for a total of $30,000 in one year. Also, if that child is married, you could opt to give up to $60,000 to the couple and avoid taxes. (As long as you and your partner are giving to your son-in-law/daughter-in-law as well as your child).
Giving More
Sometimes we run across folks who want to give more than the annual gift tax exclusion. Perhaps a child is buying a house, and a parent wants to help with a larger down payment. A person can give more than the annual exclusion rate but does need to file a gift tax form. For example, say you are a single person, and you want to give $100,000 to your single son to buy a house. Your annual exclusion rate is $15,000. The additional $85,000 needs to be reported to the IRS on form 709, which alerts the IRS that you have given a portion of your estate tax exemption to your child early. The current federal estate tax exclusion amount is $11,700,000 in 2021. Assuming this is your first gift, then you would not pay any transfer tax. Upon your death, the $85,000 gift is deducted from the current estate tax exemption.
Watch Other Taxes
So far, we’ve been talking about avoiding transfer tax (gift and estate tax) in giving funds to our family. If you have the cash on hand to gift, you don’t have to worry about any other types of tax. However, if you need to sell investments or withdraw funds from an Individual Retirement Account, you may have an income tax to pay.
Cashing Out an Investment Account
If you sell some investments inside an investment account, such as an individual or joint account, and those investments have grown since you purchased them, you will have capital gains. Capital gains are the difference between the cost basis – or purchase price – and the sale price. If you fall into the 22% marginal tax bracket or above, you will pay tax on the growth amount. Generally, capital gains tax ranges from 15% up to 23.8% depending on how much income you have. Currently, this tax is a cheaper tax than ordinary income (the type of tax your paycheck is taxed). So, let’s say you purchased a mutual fund for $75,000, and it’s now worth $100,000, so you cash it out. Your gain is $25,000. If you fall into the 15% capital gain bracket, your capital gains tax will be $3,750 ($25,000 X 0.15). Note that if you live in a state with income tax, you will pay state tax.
Alternatively, in this case, instead of selling an asset to get cash to gift to a loved one, you could give the asset and have your loved one sell the investment to get cash. Your loved one won’t escape capital gains, but if they are in a lower capital gains tax bracket, they will pay less tax and net more from this strategy.
Withdrawing from a Retirement Account
What if the funds you need for your gift are inside an Individual Retirement Account or other retirement accounts? First, let’s assume you are at least 59 ½, so you don’t have to pay a 10% penalty for the withdrawal. Then when you take out $100,000 for the gift, this withdrawal will be treated as ordinary income. How much tax you pay depends on how much other income you have. If you are single and have an additional income of $100,000, you will pay 32% federal income tax, or $32,000. Note that if you live in a state with income tax, you will pay state tax.
After Death
While some people leave some assets to charity upon their death, most of our clients also leave assets to their loved ones.
Leaving Assets to Your Spouse
If you leave your assets to your spouse and are both U.S. Citizens, your spouse won’t pay any estate taxes.
Leaving Assets to a Non-Spouse
You can leave an estate up to currently $11,700,000 to anyone without any estate taxes (This includes a non-US citizen spouse). In addition, our estate tax exemptions are now portable, so married couples essentially have twice this amount, or $23,400,000 of estate tax exemption to leave to their kids or other individuals.
Leaving Assets to Charity
If you leave any of your assets to a 501(c)3 charitable organization, you can leave any amount without incurring any estate tax for those dollars giving to charity.
Potential Changes to Taxes
The Biden administration has proposed some changes to taxes that could affect gifting.
Currently, the administration is proposing to raise the top capital gains tax from 23.8% to 43.4%—the increase is for people whose income is over $1,000,000. So in the scenario where you sell investments to gift money to your children, and you have income over $1,000,000, then you could potentially pay almost double for capital gains tax.
The estate tax proposal will eliminate the step-up in basis, which could also cause significant tax for wealthy people. Currently, when you die, your cost basis for investments not inside retirement accounts get stepped up and effectively washes away capital gains tax. For example, if you had an investment that you paid $200,000 for and now it is worth $2,000,000, currently your heirs would receive a step-up, and the $1,800,000 capital gains would be wiped away. Under the Biden proposal, capital gains over $1,000,000 will not receive this step up. Instead, your heirs would be faced with a capital gains tax of up to 43.4% on the $800,000 of gain above $1,000,000.
If enacted, these changes would affect tax planning, and advisors may encourage people to realize gains under $1,000,000 to lower their future overall tax bill. More to come on this if this proposal would come to pass.
In summary, you can give money to people without paying the transfer tax, and if you want to gift a lot of money, you could pay no tax but do need to file a form. The most challenging part about gifting is coming up with the cash to gift. Selling an asset to get the cash is often the step in the process that produces tax.
Investment Advisory services offered through Birchwood Financial Partners, Inc. an SEC Registered Investment Advisor.
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