Nearly everyone makes gifts to people throughout the year, whether it's for special occasions like birthdays or the holiday season or just as a random act of kindness. Most people never even think about the fact that the IRS considers any gift to be a taxable gift that's potentially subject to a gift tax. Thanks to two different provisions that allow for a gift tax exclusion, the vast majority of American taxpayers will never have to file a gift tax return, much less actually pay gift tax out of pocket. Nevertheless, it's important to understand how the gift tax exclusion works so that you can stay within its boundaries whenever possible.
Annual gift tax exclusion vs. lifetime gift tax exclusion
The tax laws provide for two key tax exclusions for what would otherwise be taxable gifts. The annual gift tax exclusion is the one that most people take advantage of every day without even thinking about it. Under this rule, you're allowed to make a gift of up to $14,000 for 2015 without having to file a gift tax return or pay any gift tax. The $14,000 amount applies to gifts to any one individual, so you can make multiple $14,000 gifts to any number of different people without abusing the annual gift tax exclusion provisions. This $14,000 figure is adjusted each year for inflation, although it doesn't change unless the cost-of-living adjustment pushes it up to the next higher multiple of $1,000. Every year, you get a brand new annual gift tax exclusion to use, regardless of whether you used it the previous year.
Beyond the annual limits, you also have a lifetime gift tax exclusion that you can tap into. Under the current gift and estate tax rules, the exclusion amount for 2015 is $5.43 million. The net impact of the lifetime gift tax exclusion is that you can make additional gifts above the $14,000 annual exclusion amount and still not pay any gift tax. Unlike the annual gift tax exclusion, you'll have to file a gift tax return to claim the lifetime exclusion, even if you don't end up owing any tax at this time. Moreover, what you use now gets charged against the remaining exclusion both for future lifetime gifts and for your estate after your death.
An example can clarify the way these two gift tax exclusions interact. Say you make a gift of $34,000 to your child. Of that amount, $14,000 of that gift qualifies for the annual exclusion. That leaves a taxable gift of $20,000 that you can count against your lifetime gift tax exclusion, assuming you haven't already used it up on previous gifts. If this is the first such gift, then you'll have $5.41 million of lifetime exclusion remaining to use against future gifts and against your taxable estate once you've passed away.
Additional aspects of the gift tax exclusion rules
There are several situations in which the gift tax rules are more generous than the general rules listed above. The most common involves spouses, who are generally allowed to make gifts to each other of any amount without incurring gift tax because of what's known as the marital deduction.
Another common situation involves paying tuition or medical expenses on behalf of someone. In those cases, lawmakers have offered an unlimited exclusion for gift tax purposes for the money spent on the gift recipient's behalf. In order to qualify for this exclusion, though, you have to make the payments directly to the educational or medical institution providing the services. If you give money to a student to allow the student to pay the school, this exclusion doesn't apply. Similarly, payment for a patient's care needs to be made directly to a hospital or other facility and not to the person getting treatment.
Gift tax liability is an IRS tax trap that many people never think about. Thanks to the annual gift tax exclusion, most people don't have to think about gift taxes. But if you see yourself making larger gifts now or in the future, you'll want to make sure you take full advantage of all available exclusions and minimize your eventual tax bill.