We all want to provide for our loved ones — and one of the greatest gifts you can give someone is the gift of financial freedom.
But it’s important to bear in mind that the Internal Revenue Service (IRS) does tax certain large gifts above a certain amount.
This amount is called the “gift tax exemption,” and the IRS imposes both an annual and lifetime gift tax limit. Once you reach that limit, you’ll be expected to report and start paying tax on your financial gifts.
As always, there are a couple of exceptions and extra rules you should be aware of.
This guide explains what the gift tax exemption is, the difference between the annual exclusion limit and the lifetime exclusion limit, and who's responsible for paying the gift tax.
What is the Gift Tax?
Before we break down the lifetime gift tax exemption and how that works, let’s take a step back and talk about the gift tax itself.
The gift tax is an IRS tax on the transfer of property from one person to another that applies when the person giving the gift (the “donor”) receives little to nothing in return.
By “little,” the IRS specifically means less than fair market value. For example, if you spent $50,000 on a new BMW and then sold it to a friend for $1,000, the IRS would probably view that sale as a gift from a tax point of view.
Congress introduced the federal gift tax in 1932 as a strategy to stop people from avoiding the estate tax by transferring all of their wealth and assets before they died.
It’s important to note that the gift tax applies to the transfer of any type of property. This includes cash, but it also includes gifting income from property you’ve sold.
That means if you sell that BMW we were just talking about for $40,000 and give all the money to your little sister, you’re probably going to be taxed on that gift.
Offering somebody an interest-free loan or reduced rate loan might also count as a gift under the gift tax rule — and that tax applies whether or not the donor intended for a transfer of property to count as a gift.
That being said, it’s important to note that there are a few exceptions in which you won’t have to pay the gift tax.
The number one way you can avoid paying the gift tax is by using either your annual gift exclusion rate or your lifetime gift tax exemption.
These exemptions are the caps that the IRS uses that allow you to gift up to a certain amount of money to somebody else without having to pay the gift tax.
We’ll break down those exact amounts and how they work in just a second.
Other gift tax exemptions include money spent on tuition or other educational expenses. You can also use an exemption for gifts to a political organization and qualifying charities. These exemptions don’t generally have numerical caps like the annual gift tax exemption and the lifetime gift tax exemption.
That being said, there are conditions surrounding these gifts. For example, in order to qualify as a charitable contribution, the organization you’re gifting assets to has got to fit the IRS definition of a qualified charity.
You can also take advantage of an unlimited marital deduction as long as your spouse is a U.S. citizen. If your spouse isn’t a U.S. citizen, you can still make tax-free gifts to them — but the amount you’re allowed to give is limited to an annually adjusted value.
What is the Gift Tax Exemption?
The IRS gift tax is designed to cover a broad range of asset classes and gifts transferred from one individual to another. But you’re allowed to gift up to a certain amount each year and over your lifetime without having to pay any taxes on those gifts.
This is referred to as your gift tax exemption (you might also hear people refer to it as the “gift tax exclusion”).
The annual gift tax exclusion allows you to gift up to a certain amount per person per year without having to report it to the IRS.
In 2021, you’re allowed to give as much as $15,000 per person per year without paying the gift tax. If you and your spouse file your taxes jointly, your combined annual limit is $30,000.
Remember, the annual gift tax exemption is based on the value each recipient gets rather than the total value of all your gifts.
This means you could theoretically give $15,000 to your daughter, $15,000 to your nephew, and $15,000 to your neighbor all in the same year without having to pay the gift tax.
But if you were to gift $16,000 to somebody, you’d have to report that to the IRS, and you may have to pay tax on that extra $1,000. More important still, that $1,000 would add up against your lifetime gift tax exemption. Again, sometimes you’ll hear people call this a “lifetime exclusion,” but both terms mean the same thing.
In 2021, you’re allowed to gift a limit of up to $11.7 million during your lifetime to those you love — and that’s on top of the $15,000 you can gift annually. You and your spouse both have access to that limit — so you’re allowed to gift a combined $23.4 million over the course of your lifetimes.
At the end of the day, the gift tax exclusion is the easiest way to avoid paying gift tax.
For most adults, the lifetime gift tax exemption is more than enough to help them build up a nest egg for the people in their lives. But even then, you’ve got to make sure what you’re gifting is always within the IRS limit.
One way to start saving for the kids you love and keep track of those gifts is to set up a UGMA custodial account for those kids. After setting up a custodial account, you’re then able to gift up to $15,000 per year toward that tax-free account or contribute up to $11.7 million during your lifetime.
If you do end up gifting above your annual or lifetime gift tax exemption, you’ll need to file a gift tax return with the IRS. This is done using IRS Form 709 — although completing and submitting a gift tax return form to the IRS doesn’t necessarily mean you’ll be asked to pay a tax on the gifts.
We’ll cover who needs to report a gift (and how) in just a minute. First, let’s take a step back and talk about how the gift tax compares to the estate tax.
What is the Estate Tax Exemption?
A lot of people confuse the gift tax exemption with the estate tax exemption, and it’s not hard to see why.
When you die, your estate isn’t normally subject to the federal estate tax as long as it's under the estate tax exemption amount. Just like the lifetime gift tax exemption, the estate tax exemption is currently $11.7 million. For a married couple, that again amounts to a combined estate tax exemption of $23.4 million.
If your combined estate is worth more than the exemption, the surplus amount will get taxed.
It’s important to note that the estate tax exemption factors in the gifts you’ve tallied up against your lifetime gift tax exemption. This means that if you’ve already reached your lifetime gift tax exemption limit by the time you die, your estate will be taxed no matter how much it’s worth.
Who is Eligible for the Lifetime Gift Tax Exemption?
The short answer is: everyone. All U.S. taxpayers are eligible to gift money to their loved ones using the gift tax exemption. This applies to both the annual gift tax exemption and lifetime gift tax exemption.
The only major exception to this eligibility rule you need to be aware of is if you’re gifting money to your spouse.
Most gifts between spouses are tax-free, thanks to the unlimited marital deduction. With this deduction, you’re allowed to gift as many assets to your spouse as you’d like — both during your lifetime or at the point of your death.
Under these circumstances, you shouldn’t have to pay the gift tax or the estate tax.
This counts for same-sex couples, as long as they’re legally married.
However, the unlimited marital deduction only counts if your spouse is a U.S. citizen. If your spouse isn’t a U.S. citizen, there’s a cap on the amount of money you’re allowed to gift them without having to pay taxes on it.
That being said, the annual gift tax exemption for non-citizen spouses is a lot higher than the normal annual gift tax exclusion of $15,000.
In 2021, you’re allowed to gift up to $159,000 per tax year to a non-citizen spouse without having to pay the gift tax.
Who Pays the Gift Tax?
If you gift cash or assets that are greater than your annual gift tax exemption, you’ll be expected to report that gift tax to the IRS. You may then need to pay a tax on that gift, if you’ve exceeded your lifetime gift tax exemption.
Generally speaking, the person giving the gift (the “donor”) is the person who is going to be responsible for paying the gift tax. That means if you give your son $16,000 as a gift for Christmas one year, you’ll need to be the one to report that gift to the IRS — not your son.
There are a couple of exceptions to this rule, though.
Under certain special arrangements, the person receiving the gift (the “donee”) can agree to pay the gift tax instead of the donor. This is normally done by special agreement to help the donor avoid hitting their annual gift tax exemption or their lifetime gift tax exemption.
For example, let’s say you’ve already given your granddaughter $10,000 during the current tax year, and then you give her another $10,000.
That would bring you $5,000 over your annual gift tax exemption. But to prevent you from running over your annual exemption, your granddaughter could agree to report that overspill on her tax return instead.
Another exception to the rule is if the donor dies before they can report a gift to the IRS. In this case, the executor of the donor’s estate is going to be responsible for reporting the gift.
Regardless of who agrees to report the gift to the IRS, this needs to be done via Form 709. This is also commonly referred to as the “Gift Tax Return,” and it should be submitted alongside your normal tax return.
That means you need to file Form 709 after January 1 and no later than April 15 of the year after you’ve given the gift in question.
We all want what’s best for our loved ones. So it only makes sense to want to gift your wealth to help build a financial nest egg for future generations.
But at the end of the day, it’s absolutely critical that you understand all of the tax obligations you might be getting into when you gift cash or assets.
The IRS does allow you to gift a certain amount to others, and this takes the form of the annual gift tax exemption and the lifetime gift tax exemption.
As long as you’re aware of both types of gift tax rates and report any overspill to the IRS, you should be able to start gifting to those you love without having to pay the gift tax — and one of the best ways to do this is to use a UGMA custodial account.
Ready to start gifting? Download the EarlyBird app now and help the children you love to start building a financial future.
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.