Americans can give away millions of dollars tax-free during their lifetimes, but the rules are a bit complicated. To understand how much you can give, you need to know the annual gift tax exclusion, and how estate taxes work. If you have a high net worth, you can potentially use these rules to save your heirs millions of dollars.
The annual gift tax exclusion
The first part of the answer involves the annual gift tax exclusion, which is currently $14,000 per year, per person. This applies to monetary gifts, as well as to the fair market value of gifted property. You can give up to this amount to as many people you'd like every year, and the federal government won't tax one cent. For example, if you have five children and fifteen grandchildren, you can give them each $14,000 per year. That's $280,000 in tax-free gifts every year.
If you're married, you and your spouse can each make an annual tax-free gift. In other words, you and your spouse together can give every recipient up to $28,000 per year.
If you give a gift worth more than the annual exclusion amount, you won't necessarily need to pay any tax on the gift. It simply counts against your lifetime exclusion amount for estate tax purposes.
It's also worth noting that gifts to your spouse are not counted. You can generally give as much as you'd like to your spouse, 100% tax-free. The same can be said about gifts that pay tuition or medical expenses for someone, as these qualify for a special exclusion.
The lifetime exclusion
For the 2017 tax year, the IRS allows a lifetime estate tax exclusion of $5.49 million. This includes any money and property that you leave to your heirs, as well as any taxable gifts you give while you're alive. As a basic example, if you give your grandchild a $100,000 gift in 2017, say, toward the purchase of a first home, the $86,000 that is more than the annual exclusion amount will reduce your lifetime exclusion.
We'll get to some more detailed examples later, but essentially, the answer to the question "How much money can you gift tax free?" is $5.49 million, plus any gifts you give that are $14,000 or less per person per year.
Married couples get twice the exclusion, which brings the total to nearly $11 million.
Estate tax rates
There are actually 12 different tax brackets for calculating the federal estate tax, ranging from 18% for the first $10,000 to 40% for $1 million or more.
However, the estate tax brackets aren't used in practice, other than the top bracket. The lifetime exclusion I mentioned is technically structured as a unified credit against the estate tax. Specifically, there is a $2,141,800 unified estate tax credit, which is the amount of tax that would be due on a $5.49 million estate, according to the estate tax brackets.
This system of unused estate tax brackets may sound quite complicated, but the result is that all estates exceeding the lifetime exclusion are subject to a 40% tax rate on the amount in excess of $5.49 million.
What about state taxes?
In addition to the 40% federal estate tax rate, 14 states and Washington, D.C., have their own estate and/or inheritance tax rates. Many of these states have a different exemption amount than the federal $5.49 million amount. For example, Massachusetts' estate tax rates range from 0.8% to 16%, and only the first $1 million is exempt.
Here's a graphic from the Tax Foundation that can show you whether your state taxes estates, inheritances, or both:
How the gift tax rules can help your estate planning: An example
Let's say that you have a $10 million estate, including the value of cash, investments, and property. For simplicity, we'll assume you live in a state without its own estate tax.
If you die with a $10 million estate, the first $5.49 million is excluded from federal taxation. The remaining $4.51 million is subject to the federal estate tax at a rate of 40%. Therefore, approximately $1.8 million in tax will be taken from the estate, leaving $8.2 million to be distributed to your heirs.
On the other hand, let's say that you started giving away your money 10 years before you die. You have three children, all of whom have spouses, and you also have six grandchildren. (Note that you can gift money to non-relatives tax-free as well; this is just an example.) So, every year, you give $14,000 to each of these 12 people. This translates to $168,000 per year, or $1.68 million over the 10-year period. At the time of your death, of the remaining $8.32 million in your estate, just $2.83 million is taxable, resulting in a $1.13 million estate tax.
By giving away some of your money each year for a decade instead of simply allowing your heirs to inherit everything after you die, you've saved them about $670,000 in estate taxes.
Of course, this is a simplified example. There's no way to predict when you have 10 years left to live, and the exact value of your estate is likely to fluctuate quite a bit over a decade. The point, however, is that taking advantage of the annual gift tax exclusion can help you significantly lower the taxes on your estate, and can allow more of your wealth to stay in your family.
Will it even matter?
No discussion of gift and estate taxes in 2017 would be complete without mentioning the possibility that federal estate taxes may not matter for much longer. President Trump and many other Republicans have proposed getting rid of the estate tax, and with a Republican-controlled Congress, it could happen.
However, smart estate planners don't gamble on favorable legal changes that might happen. Therefore, if you want to be sure your estate tax is as low as possible, it's important to take advantage of the current gift tax exclusion rules.