Legislation enacted in 2017 temporarily doubled the federal lifetime estate and gift tax exemption — from $5 million to $10 million, indexed for inflation — through 2025. Without further legislation, the exemption is scheduled to return to its previous level of $5 million, to be indexed for inflation, on January 1, 2026.
For affluent families, the temporary increase provides a window of opportunity to transfer substantial amounts of wealth tax-free. But even those with more modest fortunes should consider taking advantage of the exemption while it is available.
Potential tax savings
For 2020, the inflation-indexed estate and gift tax exemption is $11.58 million. The following scenario shows how the increased exemption can potentially save millions of dollars in tax.
Anne, a single taxpayer, dies on January 1, 2026, with an estate valued at $15 million. Assuming the exemption amount has dropped to an inflation-adjusted $6 million and the top marginal estate tax rate is 40%, her estate's tax liability is $3.6 million.
Suppose, instead, that Anne took advantage of the increased exemption and made $11 million in tax-free gifts in 2020. Assuming her estate is worth $4 million when she dies ($15 million – $11 million), her estate's tax liability is only $1.6 million. The $11 million in gifts reduce the exemption. By seizing the opportunity to make large gifts while the exemption was elevated, Anne avoids $2 million in estate taxes.
If the ability exists, it is advantageous and prudent to gift at or near-maximum exemption levels at the current time. There will not be adverse consequences if substantial gifts are made now and future legislation lowers the exemption below the amount of those current gifts.
When considering the potential estate tax savings, keep in mind that gifting assets that you expect to appreciate in value, such as stock or real estate, may trigger future additional income taxes in the hands of your heirs. That is because property transferred by gift generally retains your tax basis, while property transferred at death receives a "stepped-up basis" equal to its fair market value on the date of death. Therefore, you should weigh the expected estate tax savings against the potential income tax costs to the recipients should they sell the assets.
Even if it seems like you will never come close to using up your gift and estate tax exemption, it may pay to use tried-and-true estate planning strategies — such as making annual exclusion gifts and direct payments of tuition or medical expenses on behalf of your loved ones. The annual exclusion allows you to gift up to $15,000 per year (for 2020), tax-free to any number of recipients, reducing the size of your estate without using any of your lifetime exemption.
Married couples who split gifts can transfer up to $30,000 per recipient. So, for example, a couple with three children and seven grandchildren can give away up to $300,000 per year. In addition, you can pay any amount of tuition or medical expenses on behalf of your children, grandchildren or others — without triggering gift taxes — so long as the payments go directly to the educational institution or health care provider.
What if you are not in a position to make large gifts now, but are concerned that the exemption will be drastically reduced in the future? Regular annual exclusion gifts and direct payments of tuition and medical expenses can provide a hedge against future tax law changes. These strategies may enable you to shelter substantial amounts of wealth from taxes while preserving your exemption.
Have a plan
Changes in the gift and estate tax exemption can have an enormous impact on the amount of wealth available to benefit your heirs. In recent years, some lawmakers have proposed reducing the exemption to $3.5 million, or even as low as $1 million. It is critical to consider a potential reduction in the exemption after 2025 (with no further legislation), as well as the risk that it may be reduced even further.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.