Gift-giving season is upon us, and for many people, coming up with the cash to afford presents for loved ones is a huge challenge. For wealthier gift givers making larger gifts, there's another issue to keep in mind: whether you'll owe any gift tax to the federal government.
Gift taxes are complicated. Tax rates on taxable gifts are high, but there are several provisions you can use to escape the tax entirely. Based on current law, it's rare for anyone to owe any gift tax. Below, we'll walk you through what you need to know.
How the gift tax works
The key to understanding how the U.S. taxes gifts is that the tax system seeks to combine gifts you make during your lifetime with bequests from your estate at your death. What that means is that dead or alive, any money that you transfer to someone else is potentially subject to gift and estate tax.
In order to avoid taxing everyone on the tiny gifts they make throughout the course of the year, though, lawmakers recognized the value of letting people make some gifts tax-free. The annual exclusion amount gives everyone the right to make gifts up to a certain amount each year to someone without having to worry about anything related to gift taxes. For 2020, that amount is once again $15,000, the same as it's been for several years.
The annual exclusion amount applies to each recipient of a gift from a donor. So you can give up to $15,000 to one person while making another $15,000 gift to someone else -- all without triggering any gift tax.
Why big gifts still might not trigger gift tax
If all your gifts are under $15,000 for the year, then you're all set. But even if you make bigger gifts, you still might not owe any gift tax.
There are two reasons why. First, there are some gifts that you're allowed to make tax-free in larger or even unlimited amounts, including:
- Gifts to spouses who are U.S. citizens
- Gifts to charity
- Gifts for tuition and qualified educational expenses that you make directly to the educational institution
- Gifts to cover medical expenses for someone else that you make directly to the provider of the medical services
Note that for gifts related to educational or medical purposes, it's critical for you to make the gift directly to the institution in question. If you give it to the student or patient first, then it doesn't qualify for the exclusion and can get treated as a taxable gift.
In addition, even if your gifts don't qualify for any of those exemptions, you're also entitled to a lifetime exemption from gift and estate tax. In 2020, that exemption amount jumps to $11.58 million.
How it all adds up
To understand this better, consider an example. Say you make $15,000 gifts to three different people and give a fourth person $75,000. The three $15,000 gifts all qualify for the annual exclusion and therefore have no gift tax consequences. The fourth exceeds $15,000, making $60,000 of the gift potentially taxable.
If the fourth person is your spouse, then you'd qualify for the unlimited marital deduction, and you still wouldn't have any gift tax consequences even on the $60,000. If the recipient of that gift isn't your spouse, then the $60,000 would be taxable. However, you'd still get to use your $11.58 million lifetime exemption amount, and you'd have $11.52 million left to use for the rest of your life and in your estate.
Make gifts worry-free
Many people are scared of the gift tax when they're doing their tax planning, but it really affects very few people. With a $15,000 annual exclusion continuing for 2020, gifts won't be a tax problem for the vast majority of Americans in the coming year.