If you know that you want to leave behind money for your family members, is it better to leave the money as a gift while you are still living or as an inheritance after death? Both of these options have different tax consequences. We’ve gathered what you need to know in order to compare giving gifts versus leaving inheritances to your beneficiaries.
Who Should Give and Why
Most people are worried about having enough savings to live on during their retirement. However, some people have so much saved that it is highly unlikely that they will spend it all in their retirement years. If you are someone in this fortunate circumstance, it may make sense for you to consider giving some money away rather than ultimately passing it all along as an inheritance. It is likely that your beneficiaries will more highly value dollars received earlier in life, when their own savings is probably low and their spending needs are high, especially for such items as the purchase of a home or paying for children’s education. This also provides you with the satisfying experience of actually seeing the gift being received and put to use. And from a tax-planning standpoint, gifts can also lower expected taxes compared to leaving that money as an inheritance.
Federal Taxation of Gifts vs Inheritance
To compare the taxation of gifts with the taxation of inheritance, it is important to know that there are two kinds of “death taxes”: 1) estate taxes and 2) inheritance taxes. Estate taxes are owed by the decedent’s estate whereas inheritance taxes are owed by those who inherit the decedent’s assets. Economically there is no difference between the two. And as a practical matter, even inheritance taxes are generally paid by the executor of the estate before assets are distributed to beneficiaries.
There are two levels of government that may collect death taxes: 1) the federal government and 2) state governments. Fortunately, the federal government currently has a generous “lifetime exemption” that allows assets to pass to beneficiaries free of federal taxation in most cases. Under current (2021) federal tax law, taxpayers are allowed a lifetime exemption of $11.7 million, or $23.4 million for a married couple. It was doubled by Donald Trump’s signature tax legislation, the Tax Cuts and Jobs Act of 2017. Beyond that high level of wealth, the federal estate tax is a flat 40%. The exemption amount is indexed for inflation but is set to expire at the end of 2025 unless Congress extends the deadline. That means that it could revert back to roughly half of its current level after 2025.1
As of 2021, each taxpayer is allowed an annual gift exclusion of up to $15,000 per year per recipient without any gift taxes or paperwork. Under an arrangement known as “gift splitting,” a married couple can give away up to $30,000 per year per recipient without any reduction in their lifetime exemptions, but any kind of split requires each of them to file a gift tax return, known as Form 709.2 Even if the total of both gifts is under $15,000, if it is split, a Form 709 must be filed. This form is also required any time gifts exceed the $15,000 limit in a tax year for a taxpayer. Filing Form 709 does not require the payment of any gift tax; it merely allows the IRS to keep track of gifts in excess of the annual exclusion, which will then reduce the lifetime gift exclusion by the amount of the excess contribution. So as a practical matter, other than a minor bit of paperwork, taxpayers are able to give away very large amounts (up to their lifetime exclusions) at any time without paying any federal gift tax.3
State Taxation of Gifts vs Inheritance
Connecticut is the only state that imposes a gift tax on its residents, and then only for gifts in excess of $2 million. So, giving money away hardly ever causes a tax payment, even at the state level. Importantly, the recipient will not have to pay any gift tax either, and the gift will not be included in taxable income.4
In fact, in states with death taxes, giving away money can eventually reduce tax payments—in those states that have either form of “death tax” (either an estate tax or an inheritance tax). Pennsylvania is one of the seventeen states in the United States that has a death tax. Twelve states and the District of Columbia have an estate tax: Maine, Massachusetts, Vermont, New York, Rhode Island, Connecticut, Illinois, Minnesota, Maryland, Washington, Oregon, and Hawaii. Six states have an inheritance tax: Pennsylvania, New Jersey, Kentucky, Maryland (Maryland has both an inheritance tax and an estate tax), Iowa, and Nebraska.5 Since most of our clients live in PA, I will focus the Pennsylvania inheritance tax.
Pennsylvania Inheritance Tax
Here are the various inheritance tax rates in PA:
- Spouses – 0%
- Lineal descendants (child, grandchild, spouse or widow(er) of a child, stepchild, adopted child) and lineal ascendants (mother, father, grandmother, grandfather) – 4.5%.
- Siblings – 12%.
- Charity – 0%.
- All others – 15%.
There are no “de minimus” exemptions or exclusions in PA. The first dollar is taxable. It must be paid within 9 months. If paid within 3 months, the amount due is discounted by 5%. Nearly all property is taxable, including not only liquid financial assets but also illiquid business interests, as well as personal property such as motor vehicles, collectables, jewelry, and household furnishings. Property in revocable trusts is taxable. (Some irrevocable trusts may avoid the inheritance tax.) Any PA real estate, even if owned by a decedent who was not a PA resident, is taxable. Real estate outside of PA is not taxable by PA, however.5
Given the high PA inheritance tax rates applicable to siblings and others (12% and 15%, respectively), it would be especially attractive from a tax standpoint to gift assets intended for these recipients before they become taxable as an inheritance. The 4.5% rate applicable to most other family members is not as punitive, but even that rate might encourage some level of gifting to reduce the taxes that will ultimately be due.
Do not assume that you can leave this to the last minute. Like some other states, PA has laws that prevent “deathbed gifting.” Any gifts over $3000 within 12 months of death will be taxable.4
Although life insurance is not subject to inheritance tax, the fees and costs associated with life insurance make it an unattractive estate planning tool in many cases. The commissions generated from selling it can be very lucrative for the insurance agent, however, which is why many unsuspecting taxpayers are persuaded to buy it. Often times, the selling agents will use the “avoid probate” mantra. At least in PA, however, probate is relatively quick and inexpensive.
Other Tax-Smart Ways to Pass Along Assets Before Death
Gifting is not the only way to provide financial support to beneficiaries. Payments made directly to a medical services provider (e.g., doctor, hospital) or to an educational institution for tuition are not treated as taxable gifts, and they don’t even count against the annual $15,000 limit. Also, like gifts under the annual $15,000 exclusion, these payments do not use any of your lifetime exemption and do not require the filing of a gift tax return (Form 709). Contributing to a 529 plan can also be very attractive because of the tax-free growth, and it will not affect the student's financial aid if the account is owned by the benefactor and not the student and disbursements are delayed until the final two years of college. (The FAFSA form has a two-year lookback.)6
In most cases, gifting securities or property that has appreciated or may appreciate may not be as tax-efficient as giving cash-equivalent assets. The gifted property is not subject to any “step-up in basis” as would apply at the death of the benefactor under current law. When the beneficiary sells the asset, capital gains taxes will be due. 6
On the other hand, giving highly appreciated stock is often a very tax-efficient way to give to charities. The donor may not only get a tax deduction (if itemizing), but the donor also avoids paying capital gains on the donated stock and because it is tax-exempt the receiving entity never pays any capital gains.
For those who are subject to required minimum distributions (RMDs) in their IRAs, a Qualified Charitable Distribution (QCD) of up to $100,000 can be an attractive way to give. It will reduce taxable income and therefore reduce income taxes.7
People with substantial assets should seek the help of an experienced estate planning attorney to advise them on the best strategies to use in their particularly circumstances. This would certainly including anyone whose assets may exceed the expected lifetime exemption, which after 2025 may well be only about $6 million. (For a couple, the it would be $12 million, but the $6 million limit would still apply to the second to die.) Various kinds of trusts are often used, and drawing up these documents requires specialized knowledge. At Sapient Investments, we refer clients to local estate planning attorneys.
This content is developed from sources believed to be providing accurate information, and provided by Sapient Investments. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.