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Annual Exclusion Gifts: A Simple Way to Transfer Wealth

By Linda Yang, Financial Planner, First Republic Investment Management
March 28, 2022

Gifting during your lifetime can be an effective estate planning strategy with multiple benefits. Lifetime gifting can help you reduce estate taxes and shift future appreciation out of your estate while providing your beneficiaries with immediate use and enjoyment of the transferred assets. Use of the annual gift exclusion is one of the more fundamental and highly effective ways to begin transferring wealth during your lifetime to the people you love.

Understanding the basics

1. Federal gift and estate taxes

Under the current U.S. transfer tax system, all lifetime gifts and bequests made at death in excess of certain dollar thresholds are subject to gift and estate tax rates as high as 40%. This threshold, known as the “basic exclusion amount,” is a combined lifetime gift and estate tax exemption currently set at $12.06 million per donor in 2022.

2. Additional shelter

In addition to the lifetime gift and estate tax exemption, the Internal Revenue Code allows donors to gift up to $16,000 (in 2022) to each of an unlimited number of recipients during a calendar year. This “annual gift exclusion” amount is indexed to inflation (subject to $1,000 increments). Annual exclusion gifts are not included in the calculation of gift tax liability. As a result, annual exclusion gifts will not count against the donor’s lifetime gift and estate tax exemptions.

A regular program of annual exclusion gifting can successfully transfer a significant amount of assets and future appreciation to your beneficiaries while effectively reducing your taxable estate.

3. Other gift tax exclusions

Gifts made to U.S. citizen spouses are already fully deductible under the unlimited marital deduction. Gifts to non-U.S. citizen spouses, however, are not eligible for the unlimited marital deduction; rather, they are eligible for a special annual gift tax exclusion ($164,000 per year in 2022).

In addition, donors may pay an unlimited amount of educational and medical expenses on behalf of any donee without incurring a taxable gift, as long as payments are made directly to the healthcare provider or educational institution.

4. Gift splitting

A married donor can effectively double annual exclusion gifts to each recipient by electing to “gift-split” with a spouse. For example, in 2022, so long as both spouses consent, a married donor can give $32,000 (instead of only $16,000) to a single recipient by splitting the gift with a spouse.

Certain gifts don’t qualify for the annual gift tax exclusion

Only gifts of a present interest qualify for the annual gift tax exclusion. The recipient must be granted immediate and unrestricted use, possession or enjoyment of the property. In contrast, gifts of future interests (such as gifts of a remainder interest or other types of delayed interests) do not qualify for the annual gift tax exclusion.

Gift tax returns

In general, donors must file a federal gift tax return (Form 709) if they gift more than the annual exclusion amount to any recipient during a particular calendar year, or if gift splitting is elected. In some cases, donors are well-advised to file a gift tax return to document gifts even if no portion of the donor’s lifetime gift tax exemption was used and no immediate gift taxes are due.

Timing of annual exclusion gifts

The annual gift exclusion amount is calculated on a calendar year basis and does not carry over from year to year. As a result, annual gifts must be made by December 31 of each calendar year, and any unused annual gift exclusion amounts result in lost tax-saving opportunities for that year.

Making gifts in installments over multiple years can help leverage the annual gift exclusion and reduce exposure to gift taxes.

Chart: Annual exclusion gifts and the effect of compound growth

A regular annual exclusion gifting strategy combined with compounding investment growth can help donors transfer substantial amounts of wealth out of their estates over time without using any of their lifetime gift exemption.

The chart below illustrates the effect of compounding growth on a program of annual exclusion gifts from two parents to a grantor trust for the benefit of a child over a 30-year period. The illustration assumes annual exclusion gifts of $32,000 per year (indexed for inflation at 1.1%) for 30 years, a 5% annual growth rate, no distributions, and the income taxes on the trust income are paid by the grantors. Under these assumptions, the trust is projected to grow to over $2.5 million by the end of the 30-year period.

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Gifting recipients and methods

The gift tax and exclusion amounts apply whether gifts are being made to a stranger or to a close family member (except U.S citizen spouses). However, it’s important to consider each individual recipient when determining the appropriate gifting vehicle.
 
When making gifts to children, their status as a minor might be one of the considerations used in determining the gifting vehicle. Children cannot legally have unrestricted access to the funds until they reach the age of majority. Giving children valuable property before they reach adulthood also raises the important question of who will manage the property on the child’s behalf. You can arrange for an adult to manage the property by establishing an irrevocable trust, a custodial account authorized by state law, or a Section 529 educational savings plan.

Gifts to irrevocable trusts

Different types of trusts may be set up for the benefit of the recipients of annual exclusion gifts. One type of trust is the Section 2503(c) Minor’s Trust, which is a separate legal entity established to hold gifts in trust for a child.

Gifts to Section 2503(c) Minor’s Trusts qualify for the annual gift tax exclusion as long as:
  1. The contributions to the trust are irrevocable,
  2. The trust’s principal and income may be used for the child’s benefit before the child reaches age 21,
  3. All undistributed principal and income are distributed to the child on their 21st birthday, and
  4. The trust assets are includible in the child’s estate if the child dies before reaching age 21.

Since gifts to the trust are irrevocable and trust assets may grow substantially over time, donors should fully understand that the child will have complete control over the assets at age 21.

Gifts to Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act (UGMA) custodial accounts

A gift to a custodial account established under the Uniform Transfer to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) can qualify for the annual gift tax exclusion. The UTMA and UGMA provide simplified ways to transfer assets to minor children without requiring the services of an attorney to draft trust documents or the court appointment of a trustee:
  1. The terms of UTMA/UGMA custodial accounts are established under state laws instead of a trust document.
  2. The donor appoints a custodian and irrevocably gifts assets for the benefit of the child.
  3. The custodian is able to control the management and use of the assets, but only until the child reaches the age of majority (varies by state).
  4. Upon reaching the age of majority, the trust terminates and the child has the legal right to use the assets for any purpose.

Gifts to Section 529 plans

Contributions to a Section 529 plan can also qualify for the annual gift tax exclusion. Section 529 plans can grow tax-deferred while distributions for qualified education expenses are generally not subject to income taxes. (Under the Tax Cuts & Jobs Act of 2017, the definition of qualified education expenses was expanded to include up to $10,000 per year, per student for private K-12 education expenses.) Contributions to Section 529 plans are considered completed gifts for estate tax purposes and generally not includible in the donor’s estate.

Subject to specific rules, Section 529 plans allow the frontloading of up to five years of annual exclusion gifting in one year without triggering gift taxes. For example, rather than contributing $16,000 per year over a five-year period, a donor could instead make a lump-sum contribution of $80,000 in year one (5 x $16,000), as long as no other annual exclusion gifts are made to that beneficiary during the five-calendar-year period. Together, two parents could fund a child’s Section 529 plan with an upfront lump-sum contribution of $160,000.

When electing to make a five-year lump sum contribution, the donor should file a gift tax return (Form 709) in order to pro-rate the gifts over the five-year period. If the donor passes away before the fifth calendar year, the contributions allocated to the years after the donor’s death are includible in his or her taxable estate.

Select the appropriate gifting strategy for your situation

An ambitious gift-giving program may not be appropriate for everyone. If parting with your wealth makes you feel uncomfortable or fearful that you will someday be without the money you need, proceed with caution. Your first priority should be to ensure that you are able to sustain your lifetime spending needs. However, being able to help family members or friends can also provide you with immense satisfaction. Annual exclusion gifting can be a powerful wealth transfer strategy and your advisor can help determine the strategies that are appropriate for you and your family.

The strategies mentioned in this article may have tax and legal consequences; therefore, you should consult your own attorneys and/or tax advisors to understand the tax and legal consequences of any strategies mentioned in this document. This information is governed by our Terms and Conditions of Use.