One of the greatest gifts you can give a child is financial freedom.
By investing in a child’s future, you can protect them from crippling debt like college loans, help them get on the housing ladder, start a business, chase their dreams, and take on just about any opportunity that comes knocking.
But before you start giving away your wealth, it’s absolutely critical that you know where you stand with the IRS.
Although you’re allowed to gift a certain amount per tax year (or throughout your lifetime) to loved ones, the IRS does have a gift tax limit. That means if you give a gift above that threshold, you’ll need to report that gift and possibly pay taxes on it.
This guide explains what the gift tax is, how it’s different from the estate tax, the annual exclusion limit for 2021, and how you can gift money to loved ones in a tax-beneficial way.
What is the Gift Tax?
Simply put, the IRS gift tax is a tax on any transfer of property from one person to another when the person receiving the transfer gets nothing in return.
Translation: if you give somebody a monetary gift, the so-called gift tax means you might end up owing a nominal fee to the IRS. But it’s important to note that there are a lot of exceptions to this. The amount you may end up having to pay as part of the federal gift tax can vary.
More importantly, the IRS allows for two different exclusion amounts that enable you to give gifts up to a certain amount without having to pay tax on those gifts: the annual gift tax exclusion and the lifetime gift tax exclusion.
These gift tax exclusions are commonly referred to as the gift tax limit.
Before we dive into the history and specifics of the IRS gift tax, let’s break down these two gift tax exclusion amounts.
What is the IRS gift tax limit for 2021?
For 2021, the annual IRS gift tax limit is $15,000 per person per tax year.
That means you’re allowed to give up to $15,000 each to multiple people without being required to pay the gift tax.
For example, let’s say you’ve got three kids. You could theoretically give each of your three children $15,000 every year without needing to pay a gift tax.
The gift tax exclusion amount is even higher if you joint-file your taxes with your spouse.
If gifting money as a married couple, the annual exclusion amount doubles. That means that together, you and your spouse could give up to $30,000 per year to as many people as you’d like to without paying taxes on it.
As of 2021, the lifetime gift tax exclusion is $11.7 million.
That means you’re allowed to give up to $11.7 million in gifts over the course of your life above and beyond the annual exclusion and still not have to pay tax on those gifts.
How does the gift tax work?
At first glance, the gift tax doesn’t seem super fair to everybody. After all, people work really hard to build their wealth. On the one hand, you can understand why they’d want to share that financial success with their family members.
But there is a method to the madness here.
Congress enacted the gift tax in 1932 because they realized that too many donors were dodging the estate tax by transferring all of their wealth to somebody else right before they died. This created a tax shortfall, so politicians thought it made sense to limit the amount of money a person can give to others on an annual and lifetime basis.
The gift tax applies to the gifting of any type of property or asset.
If you give any type of property (including cash) or decide to give someone income from your property without the expectation of getting something of equal value in return, it falls under the jurisdiction of the gift tax.
Now pay attention, because this one is important: the gift tax also applies to some sales below fair market value.
If you decide to do somebody a favor by selling them an asset for a fraction of its full value, the IRS might rule that the sale qualifies as a taxable gift. This same rule applies to a lot of interest-free or reduced-interest loans.
You don’t want to get caught breaking gift tax rules — so when in doubt, you should get in touch with an accountant or the IRS to find out whether the sale or loan you’re providing is taxable.
Despite the desire to clamp down on estate tax dodging, even congress members didn’t think it was fair to tax every penny somebody chose to gift their family or friends. That’s why the gift tax limit was introduced via the annual exclusion and lifetime exclusion.
These two exclusion rates tend to rise on an annual basis in line with inflation.
For example, in 2020, the lifetime gift tax limit was $11.58 million. But for 2021, that lifetime limit was increased to $11.7 million.
If you gift above your annual exclusion limit in any instance, you’ve got to report that information when you file your taxes.
To report gifted assets, you’ve got to complete and submit IRS Form 709. This applies to any transfer of cash or property exceeding your annual exclusion limits.
There are a few exceptions you’ve got to bear in mind when figuring out whether you need to submit IRS Form 709.
First off, you don’t need to file Form 709 if the gifts you’ve made are under the annual gift tax limit exclusion for the calendar year.
Tuition or medical expenses don't generally count as gifts, and gifts to your spouse aren’t bound by the gift tax limit.
That means you could “gift” your spouse $50,000 in a given year, and it would ordinarily be exempt from the gift tax — but only if your spouse is a U.S. citizen.
If your spouse isn’t a U.S. citizen, the federal tax-free amount you’re allowed to gift them is limited to an annually adjusted value.
Finally, most gifts to a political organization are exempt from the gift tax.
Who Pays the Gift Tax?
In most cases, the donor is going to be responsible for paying the gift tax. That means if you’re the one giving a large monetary gift, you need to pay the gift tax. The person receiving the gift isn’t liable to pay anything.
There can be an odd exception to this rule, but only by special arrangement. The donee of a large financial gift can agree to pay the gift tax instead of the donor, but this must be explicitly spelled out.
It might happen if the donee of a gift wants to help the donor avoid exceeding their lifetime gift exclusion limit. If the donee agrees to pick up some of the tax bill from their gift, this is done in the same way a donor would file and pay.
But the IRS default is that the person gifting is the one that needs to pay the tax — and if you reach some other type of agreement, the IRS recommends you discuss this with a tax professional.
If a donor dies before filing their tax return, the donor's executor must file Form 709.
If you’re the one paying the federal gift tax, you’ve got to complete and file IRS Form 109 alongside your taxes. You can find this online, but remember, you only need to file Form 709 if the property you’ve gifted exceeds your annual exclusion limit.
What’s the Difference Between the Gift Tax and the Estate Tax?
You’d be forgiven for confusing the gift tax with the estate tax. They are pretty similar. But the gift tax was actually introduced in the 1930s to address a loophole in the estate tax.
The U.S. has taxed the estates of people since 1916, and the federal estate tax applies to any property that gets transferred as a result of somebody’s death.
The key difference between the estate tax and the gift tax is that the gift tax applies to living people rather than people who have died. It prevents people from avoiding the estate tax by transferring their wealth toward the end of their lives.
In addition to the gift and estate tax, you’ve also got the generation-skipping transfer tax (GSTT).
This is a tax on property transfer by either gift or inheritance to a beneficiary who is not the donor’s spouse. But to qualify under the GSTT, the beneficiary needs to be at least 37-and-a-half-years younger than the person giving the gift.
What is the Gift Tax Exclusion?
We’ve already briefly covered the IRS gift tax limit for 2021. But there are a few extra elements of the gift tax exclusion you need to bear in mind.
While the IRS gift tax covers a pretty wide range of gifts and assets, you’re allowed to gift up to a certain amount per person each year and annually over your lifetime without having to pay any tax.
In 2021, you can give up to $15,000 to someone in a year and generally not have to report it to the IRS.
But if you give more than $15,000 worth of cash or assets over 12 months to any one person, you need to file a gift tax return.
Just because you’ve filed Form 709 doesn’t necessarily mean you’re going to be required to pay a gift tax. But you still need to file IRS Form 709 to disclose the gift.
The lifetime exclusion limit for 2021 is $11.7 million.
Once you exceed your $15,000 annual exclusion, the amount you’ve gone over gets taken away from your lifetime exclusion.
If you eventually use up your lifetime exclusion, then you’ll be taxed for any amounts you gift over your annual exclusion.
It’s also really important for you to remember that the annual gift tax limit is per recipient rather than the total sum of every gift you’ve given in a year. That means you’re allowed to give away more than $15,000 in 12 months. You’ve just got to split who you’ve gifted that money to.
For example, let’s say you’ve got a nephew, a niece, and a cousin all starting college in the fall.
To give them a helping hand to cover their first semester’s worth of tuition, you’re allowed to gift cash to all three of the kids in your life without paying the tax — as long as you’re giving each child under $15,000.
That means you could give each kid $12,000 per year to help them cover the cost of their tuition without having to pay the gift tax, even though you’d be giving the three kids a total of $36,000 per year.
Again, it’s also worth bearing in mind that the annual exclusion is only $15,000 per person if you’re filing as a single person.
If you and your spouse file your taxes jointly, the annual gift tax limit doubles. That means you and your spouse can gift a combined $30,000 per year to a child (or anybody else) in your life without having to file a gift tax return form.
As we’ve already touched upon, gifts between spouses don’t trigger the gift tax.
The IRS allows for unlimited financial gifts to your spouse — which means you could theoretically gift your spouse $15 million and not have to pay the gift tax. But as always, there are a couple of exceptions to bear in mind.
As we mentioned earlier, the spouse exemption only applies if your spouse is a U.S. citizen. If your spouse is from overseas, the amount you can gift them tax-free is limited to an annually adjusted amount.
It’s also important to note that you may need to pay the gift tax even if you’re not a citizen and don’t live in the U.S.
The gift tax applies to most transfers by a gift of U.S.-situated property. That means if you gifted a $300,000 house to your British sister-in-law, that gift would probably be taxable under the gift tax.
Finally, don’t forget that the gift tax doesn’t apply to gifts you give to nonprofits and charities. The IRS considers these charitable donations, and you can generally claim those as tax deductions.
What’s the Best Way to Gift Money to Children
If you want to gift money to the children in your life, there are a few extra considerations you should bear in mind. The biggest issue you’ve got to think about is the most strategic and tax-efficient way to gift funds to the kids you love.
Everybody knows that the easiest way to gift money to a minor is to just give them cash. But let’s get real here, if you just hand over cash to a kid, there’s a good chance that money will end up getting wasted on some passing trend at the drop of a hat.
That’s why you should consider a tax-beneficial investment like a UGMA custodial account.
A custodial account is a tax-beneficial investment vehicle that an adult can use to invest in a child’s financial future.
Custodial accounts are a popular way to gift money to children because they enable you to save for a kid’s future in a tax-efficient way.
Because everything you put into a custodial account is the legal property of its child beneficiary, unearned income generated through the account is taxed at the child’s lower tax rate up to a certain amount. That can save families a decent amount of money.
Custodial accounts also have flexible withdrawal rules.
You’re allowed to make considerable withdrawals before a child comes of age, as long as that withdrawal is for their direct benefit. And unlike a 529 plan, when the kid you’re investing for comes of age, they can spend the money in their account on whatever they want.
If you want to make the most of those benefits, you should check out EarlyBird.
EarlyBird takes the standard UGMA account to the next level by offering adults a range of portfolio options to invest in a child’s future.
Gifting money to an existing account can be done in just a few swipes, and friends, relatives, or anybody else can personalize their gifts with a video message so that kids can understand how meaningful that investment truly was.
At the end of the day, the gift tax is something everybody needs to be aware of. There are quite a few rules in place to ensure that large gifts are appropriately taxed, so you’ve got to be aware of all the rules to make sure you’re staying on the right side of the IRS.
But thanks to the gift tax limit, you’re allowed to avoid paying the gift tax in certain situations.
That limit all depends on your annual and lifetime exemption and how much you’re gifting to someone.
If you want to gift money within your gift tax limit, one tax-beneficial investment solution is to use a custodial account.
Download the EarlyBird app now and start gifting towards the financial futures of the kids in your life.
This page contains general information and does not contain financial advice. All investments involve risk. Any hypothetical performance shown is for illustrative purposes only. Actual investment performance may be different for many reasons, including, but not limited to, market fluctuations, time horizon, taxes, and fees. Please consult a qualified financial advisor and/or tax professional for investment guidance.