Dear Carrie,
Can you please explain how gift taxes work? My parents have mentioned that they intend to give all of their kids and grandkids financial gifts this holiday season, but I don't know what that means tax-wise for them--or for us.
--A Reader
Dear Reader,
It's wonderful that your parents are in a position to help the family financially. I'm a big believer in one generation helping the next, and the holidays are an excellent time to share one's good fortune. And fortunately for most people, gift taxes aren't an issue.
Currently gift tax laws allow for a pretty hefty exclusion for the giver, so gift taxes affect only a small percentage of the population. Plus, gifts aren't considered income to the receiver, regardless of the amount. Likewise, estate and inheritance taxes--which go hand-in-hand with gift taxes and share some of the same exclusions--generally concern only the super wealthy.
But with times being what they are--and taxes being a hot topic--I think it's smart for everyone to at least understand the basics. Your parents may be well aware of how gift and estate taxes work, but here are some numbers you might want to review with them to show both your understanding and your appreciation of what they're doing.
What you can give tax-free annually
While technically the IRS considers any gift a taxable gift, currently an individual can give up to $14,000 a year to anyone--and any number of people--without incurring gift taxes, or even having to report the gift.
Married couples who elect to split their gifts for the calendar year can give up to $28,000 a year. This means your parents could combine their annual limit and give each of their children or grandchildren up to $28,000 during this 2016 holiday season--and none of you would have to pay taxes or even report the gift. However, if your parents decide to do this for one gift, they must split all other gifts during that year. And, although there would be no gift tax due, they would each have to file a gift tax return (IRS Form 709).
Just for the record, if your parents chose to make direct payments for tuition or medical expenses for any of you, those payments wouldn't be considered taxable gifts and aren't included in the annual limit. By doing that, they could give even more without tax consequences.
How the lifetime exclusion works
If you stay within the $14,000 annual exclusion, giving monetary gifts can be pretty simple. Things get a bit more complicated when an individual gives more than $14,000 ($28,000 for a married couple) to any one person during the course of a year.
You may have heard of the lifetime exclusion. This is the amount you can give above and beyond the $14,000 annual limit during the course of your life without incurring gift taxes. For 2016 that amount is a whopping $5,450,000, and will go up to $5,490,000 in 2017.
With such a high limit, the vast majority of people won't need to be concerned about paying gift taxes. But whether or not you ever reach the limit, you are required to report any gift that's more than the annual limit--and it's that excess that counts toward your lifetime exclusion.
Here's an example. Let's say you want to give four people $25,000 each this year--$11,000 per person over the $14,000 annual exclusion. In this case, that would be $44,000 accumulated toward your lifetime exclusion that would have to be reported.
An important qualification
Another thing anyone contemplating giving large gifts should be aware of is that to qualify for the exclusions--both annual and lifetime--a gift must be of present interest, which means that the recipient has an unrestricted right to the immediate use of the property. A gift of future interest, which is restricted in some way by a future date, doesn't qualify. Gifts of cash and property where title passes immediately are examples of gifts of present interest.
A word about estate and inheritance taxes
Again, for the record, gift taxes and estate taxes are related. One governs how much you can give away tax-free during your lifetime; the other how much you can give away upon your death. For federal tax purposes, the exclusion limits are the same. So again, estate taxes only affect a very small percentage of the population.
However, certain states also have estate or inheritance taxes (in some cases, both) and the exclusions are generally lower than the federal limits. Gifting during one's lifetime can be a viable strategy for reducing your taxable estate. Your parents might want to check into the tax rules in their state, and if estate or inheritance taxes are a concern, factor that into their giving strategy.
Making the most of the gift
Your parent's generosity can mean a lot to your family financially, but it also provides a great opportunity to sit down together and talk about saving, investing and how to make this money grow. Talk to the kids about setting goals, budgeting and thoughtful spending. Consider opening a custodial account to teach young people about investing. And, while you're discussing these things, take a fresh look at your own finances.
To me, while you're all lucky to receive this holiday windfall, the chance to focus as a family on wise money management could be the greatest gift of all.
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This article originally appeared on Schwab.com. You can e-mail Carrie at askcarrie@schwab.com, or click here for additional Ask Carrie columns. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.
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