Tax-free gifting can be a good way to reduce the taxable value of your estate. The estate tax exclusion amount is currently $5 million per person, and with indexing for inflation that sum increases to $5.25 million per person in 2013. The tax’s maximum rate is 40%.
The same rules apply to the gift tax, which is unified with the estate tax. As a result, this $5.25 million exclusion applies to both the taxable gifts that you give throughout your life and the value of your estate at death.
Thus, you can shelter a total of $5.25 million between lifetime gifting over and above the annual gift tax exclusion ($14,000.00 per person in 2013) and what you leave to heirs at your death. This means that if you use this unified exclusion to do any tax-free gifting during your lifetime, then you are reducing what will be left to apply to your own estate.
There is another exemption that can increase your tax efficiency. Each year, an individual can give gifts totaling up to $14,000 to any number of different recipients each year before the gift tax will apply. This amount increases from time to time with inflation.
Let’s say that you have someone in the family who has yet to attend college. You don’t want to give this person a direct cash gift, but you would like to take advantage of the exclusion and set aside some money for this family member, but only for his or her college expenses.
In this case, you fund a 529 college savings account with your annual gift tax exclusion. The assets in the account are invested much like a 401(k) account. The earnings are not taxed as long as the student ultimately uses the funds for qualified higher education expenses. You can stay in charge of the account and determine when and if the money is released. You can even change the plan account beneficiary from time to time. If you die, the funds in the plan are (subject to a certain limited exception) not included in your taxable estate at death.
It should be noted that you can actually place as much of $70,000 in the account all at once and spread the contributions over five years when you are filing gift tax returns. This allows you to write a big check that would exceed the annual gift tax exemption, but spread the gift over 5 years and thus shelter 5 years’ worth of annual exclusion gifts. (5 X $14,000 = $70,000). Your spouse could do the same, thereby doubling what you can gift free of tax.
Here’s a neat trick. Any person can be a beneficiary of a 529 plan, including your spouse. So you could set up a 529 plan for your husband or wife, invest the funds and let them grow in value without current taxation. Unless the spouse/beneficiary is going to use the money for schooling, then when the money is withdrawn the deferred gains and earnings are taxed as ordinary income. That works just like an IRA.