You're in your golden years, and you're thinking hard about estate planning. You want to leave gifts for your heirs, but should you wait until you pass away? Or should you give some money to them now?
First, let's review the rules.
Gift tax versus estate tax
Gift tax is the tax imposed by the federal government on any transfer of property to an individual without any compensation in return. "Property" in this sense includes both tangible property, like art or furniture, and intangible gifts like stocks and cash.
Currently (under 2014 law), you are exempt from gift tax on lifetime donations up to $5.34 million. Once your donations go over that lifetime amount, they can be subject to taxes up to 40%.
However, it's essential to note that this is a lifetime exemption – meaning, that's your cap over the span of your life. The $5.34 million lifetime exemption is a well-known figure in the world of estate planning that's based on what's called the unified gift and estate tax credit.
In any particular year, you can also give a tax-free gift of up to $14,000 per recipient without dipping into the basic exclusion. This is known as the "annual exclusion." However, here's where it gets tricky because of the unified credit. This refers to the federal gift tax and estate tax, combined into one tax system. If you give more than the annual exclusion amount to any one recipient in any particular year, most people are eligible to use the unified credit so that the gift counts against your estate. For example, if you give $15,000 in 2014, $14,000 is eligible for the annual exclusion, and the remaining $1,000 is applied against your lifetime exemption, which also reduces the exemption for your estate when you die by the same amount.
Estate tax is the tax imposed by the federal government on any transfer of property (tangible or intangible) by your estate after you have passed away. It is calculated by figuring out your "gross estate" (all assets including real estate, cash and securities, business interests, etc.) and subtracting any deductions you may qualify for (such as funeral expenses and some charitable contributions). The net amount after these calculations is then added to any taxable gifts you have given that have used up your unified credit to generate your taxable amount.
Next, let's talk about the pros and cons of gifting now as opposed to later:
Giving heirs the money now
Here are some advantages to giving your heirs money while you're still alive.
- You get to see them enjoy it. If you'd prefer to see your gifts in action, giving your heirs the money now gives you a chance to see the difference it makes in their lives.
- You can advise how they spend it. If you'd prefer to see your gifts in action in a specific way, giving the money while you're still alive gives you a chance to let your heirs know how you'd prefer they spend it.
- You can give the gift in the form of paying for something. If you really want to ensure the money is spent on the thing you want it to be spent on, you can pay for something rather than giving your heirs the money for it. For example, you can pay for their wedding, make a down payment on their dream house, or pay for their tuition (which, incidentally, can qualify for the educational exclusion from gift tax).
- You can stop giving them money if you see them falling off the rails. If you plan to give your heirs free reign with their money, giving it to them now allows you to put a stop to the cash flow if you see them spending it unwisely (like buying a flashy car instead of paying for tuition or paying down their mortgage).
- You can avoid taxes up to a certain amount. For 2014, the IRS allows you to exclude up to $14,000 in gifts per heir (or $28,000 per heir if the gift is given by you and your spouse jointly). This means you will not have to pay gift tax on gifts up to that amount. If you choose to give a gift beyond that, you'll need to claim the "unified credit" (and have it count against your estate's lifetime exemption) in order to avoid paying taxes on the gift.
Waiting until you pass away
Conversely, here are some advantages to waiting until you pass away before bequeathing gifts to your heirs.
- You may need the money later. What if you find that you need the money to pay for your own expenses during your lifetime? You might need more than you think in order to enjoy your (hard-earned) retirement, pay for medical expenses not covered by insurance, or cover other long-term care costs.
- Ability to change your mind. At the moment, you might want to split your money equally among your children (or other heirs). But what happens if one of your children later makes poor decisions that make you want to disinherit that person? Conversely, what happens if one of your children gets into a major accident and requires more medical care, and therefore more financial support? You can always adjust your will to change the amount you'll be leaving heirs after you pass away, but you can't take back money you've already gifted. Waiting until you pass away gives you the opportunity to change your mind during your lifetime.
- Your heirs might appreciate it more and spend it more wisely. By waiting until you've passed away, you give your heirs a chance to "make their own way in the world" at a younger age. Rather than relying on an annual cash infusion from you, your heirs will be older and more responsible when they receive the inheritance. This might cause them to appreciate the gift more, as they will have experienced the task of earning money. (On the other hand, it might not. It's hard to predict how responsibly a person will act, regardless of their age.)
Which should you choose?
Should you give your heirs gifts now? Or wait? Ultimately, there's no "right" answer. This is a personal choice.
Here's one idea: If you're financially secure (e.g., if you have a pension from a stable institution, such as a government pension), then go ahead and give some of your inheritance now. This will allow you to direct the way that the money is spent.
But your retirement and elder-care expenses must come first. The greatest gift that you can give your family is your own personal financial stability during your golden years. If your own retirement is in question, then keep your money during your lifetime. You may need it to cover your own costs, and you don't want to be financially stressed at age 70, 80, or 100.
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Paula Pant is a contributor to WiserAdvisor.