By James Kinney
Learn more about James on NerdWallet’s Ask an Advisor
Most taxpayers will never have to pay federal gift tax regardless of the size of the gift.
I frequently get questions from clients wanting to know how much they can give to their children without incurring “gift tax.” So let’s clear this up: For 99.8% of Americans, under current tax law you are more likely to be mauled to death by a unicorn than to actually pay gift tax to the federal government.
The gift tax was designed to prevent people from avoiding federal estate tax by simply giving their money away prior to death. Here is how the gift tax works.
If you give more than a certain amount in a given year to any one individual (this amount is called the annual gift tax exclusion, and it’s $14,000 in 2015), you are supposed to file a gift tax return. If you are married, you and your spouse can each give $14,000 to an individual each year. That means you can give a combined $28,000 to as many people as you like. Most people understand this part but then fret over what happens if they want to give more than the annual exclusion.
Well, as I already mentioned, if you give more than the annual exclusion amount, you are supposed to file a gift tax return. However, that does not mean you owe any tax to the government. Remember that the gift tax was designed to keep people from avoiding estate tax. Federal estate tax applies only to estates of more than $5.43 million ($10.86 million for couples), and the gift tax shares this “unified credit” with the estate tax. Therefore, when you file a gift tax return, you can either pay the tax out of your own pocket or apply part of your unified credit toward the gift and erase the tax.
This essentially means that the only people who actually pay gift tax to the government are people with very large estates — the 0.2% whose estates are larger than the unified credit amount. Anyone else will file a gift tax return and use part of their $5.43 million or $10.86 million unified credit to avoid gift tax.
This means that a married couple making a $100,000 gift to someone — a child, say — settles with the IRS as follows:
Minus annual exclusion amount: $28,000 (2 x $14,000)
Taxable gift: $72,000
Unified credit (for married couple): $10.86 million
Minus credit used to avoid gift tax: $72,000
Remaining credit: $10.14 million.
So unless you plan to leave more than $5 million or $10 million to your kids at death, worrying about gift tax should be the furthest thing from your mind! But watch out for renegade unicorns. I hear they get aggressive during mating season.
Image via iStock.