Not a Millionaire? Better Study Gift Tax Rules

10/13/2010 04:55 pm ET | Updated Nov 17, 2011

Millionaires can probably skip this column. Most likely they've already got a team of financial professionals advising them about the best ways to pass along their wealth. For the rest of us, however, a quick refresher course on how the IRS treats gifts might prove helpful.

First, let me point out that 2010 is an odd duck year for inheritances because this year only, there is no federal tax on estates for people who die in 2010. So far, Congress hasn't decided how the estate tax will be structured in 2011, but it is possible it will be reinstated in some form or another. As for passing along gifts while you're still alive, the rules are still pretty much the same -- if a little complicated.

Avoiding the gift tax. You're allowed to make gifts of up to $13,000 per year per person to an unlimited number of people before potentially triggering the federal gift tax. (Married couples who file joint taxes can together give $26,000 per recipient.) These limits are periodically adjusted for inflation. You must file a Gift Tax Return (IRS Form 709) for any gifts that exceed these amounts.

This doesn't mean you'll necessarily ever have to pay a gift tax, however. You are allowed to bestow a total of $1 million in gifts during your lifetime above and beyond the annual $13,000 excluded amounts before the gift tax kicks in, which for most of us means never.

Also not counted toward the $1 million lifetime exclusion are:

  • Gifts to your spouse
  • Direct payments you make for someone else's tuition or medical expenses
  • Charitable contributions
  • Gifts to qualified political organizations, such as political parties, election campaign committees and political action committees (PACs)
Note that to qualify for the $13,000 annual exclusion, your gifts must be of "present interest" -- that is, there are no restrictions on the recipient being able to use the cash or property immediately; otherwise, they count toward the $1 million lifetime exclusion.

Rules for gift and estate taxes are very complex, so read IRS Publication 950 for more details. Adding further complexity, the gift tax rate for 2010 was reduced to 35 percent from 2009's 45 percent. But Congress could well raise it in 2011. You'd be wise to consult a financial planning professional. If you don't have one, the Financial Planning Association is a good place to start your search.

Open a 529 Plan. Another way parents, grandparents and others can share their resources is by contributing to a 529 Qualified State Tuition Plan to fund children's education. Contributions up to the $13,000 annual limit ($26,000/couple) will not trigger the gift tax. Alternatively, you can jump-start the account by making a one-time contribution of up to $65,000 ($130,000/couple), as long as you don't make any other gifts to that beneficiary for five years.

There are two types of 529 Plans:

  • Prepaid tuition plans, where you can prepay and lock-in future tuition at rates currently being charged by in-state colleges.
  • College savings plans, where you contribute to an account whose interest earnings grow tax-free until withdrawn to pay for eligible expenses at any college or university. You choose among several investment options at varying degrees of market risk and reward.
To learn more about how 529 Plans work, including tax implications, brokerage fees, investment risk and the potential impact on needs-based financial aid, read these guides at FinAid, the Securities and Exchange Commission and the IRS.

Open a Roth IRA for Kids. A good long-term investment in your children's or grandchildren's financial future while avoiding the gift tax is to fund a Roth IRA on their behalf up to $5,000 or the amount of their taxable earnings, whichever is less. You contribute on an after-tax basis, but the earnings grow, tax-free, until the account is tapped at retirement.

For young people, these earnings can compound tremendously over time. For example, if you made only a one-time $1,000 contribution for your 16-year-old granddaughter, at 6 percent interest the account would be worth nearly $20,000 -- tax-free -- at age 66. If she contributed an additional $50 a month going forward, it would grow to more than $210,000 at 66.

Fund Someone's Benefits. Another way to help cash-strapped loved ones is to give them cash to help pay for health, homeowner/renter's or auto insurance premiums or to fund their 401(k) plan or IRA. As long as you don't exceed the $13,000/$26,000 annual limits, any such contributions won't impact your gift tax exclusion amount.

It goes without saying that before you start handing out gifts you should make sure you're on track to fund your own retirement, have adequate health insurance, can pay off your mortgage and are otherwise debt-free. You wouldn't want to deplete your resources and then become a financial burden on others.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

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