Using Tax-Free Gifts for Wealth Transfer

Recently, higher inflation rates have changed the amounts used for calculations under various tax laws, including those governing federal gift and estate taxes. The federal gift and estate tax exemption is currently $12,920,000 for gifts made, or decedents dying, in 2023. The exemption, which is indexed for inflation, is scheduled to increase to $13,610,000 in 2024, and will likely increase again in 2025. In 2026, it will revert to $5,490,000, the exemption in 2017, adjusted for inflation since that time. Although it is uncertain whether the federal gift and estate tax exemption will ultimately be reduced to that level given the possibility of new tax legislation, certain estate planning techniques can be used currently, and will likely be available in future years, that allow taxpayers to transfer significant wealth to heirs without using the federal gift and estate tax exemption.

A simple way for taxpayers to transfer wealth over time is to make annual exclusion gifts and payments for educational or medical expenses on behalf of others. These “tax-free” gifts are allowed under current law, and the sunset provisions that will reduce the gift and estate tax exemption do not limit them.

Annual Exclusion Gifts

Under current law and applicable in 2023, every individual can give away up to $17,000 to as many individuals as he or she wants without using any federal gift and estate tax exemption. For 2024, the annual exclusion amount will be $18,000 based on the inflation adjustment. In 2023, married couples can each give $17,000 to the same individual such that their total annual exclusion gifts to any one individual are $34,000. If a couple has three children, they can give $102,000 away in annual exclusion gifts to their children without consuming any portion of their lifetime exemptions. In 2024, that amount will be $108,000. If the couple makes gifts prior to the end of 2023 and in the beginning of 2024, that will allow a total of $210,000 to be gifted tax-free to their children over the next few months.

These transfers do not have to be outright. A variety of trusts for the benefit of family members (e.g., children, grandchildren, nieces and nephews) can qualify to be the recipients of annual exclusion gifts. Establishing such trusts can provide several advantages, including:

• Protecting the assets from the beneficiary’s creditors
• Providing the opportunity to avoid federal transfer taxes on the trust property for generations
• Having a vehicle for other planning techniques, such as loans or sales (if beneficial under future law)

The following hypothetical example highlights the potential effectiveness of making annual exclusion gifts over time:

A married couple creates one or more trusts for the benefit of their two children and five grandchildren. In Year 1 (2023), the couple gifts $34,000 to a qualifying trust for each child and grandchild for a total of $238,000. In Year 2 (2024), the couple gifts $252,000, for an aggregate total of $490,000. Assuming these annual gifts were made on January 1, 2023 and January 1, 2024 and each year thereafter, annual exclusion gifts of $36,000 (ignoring future upward inflation adjustments) are made to each individual. If invested in a moderately aggressive portfolio realizing an annual rate of return of 5.5%, the potential growth may be significant, as shown below.

Hypothetical: Compounding Benefit of Gifting

Source: Neuberger Berman. Assumes a 5.50% annualized rate of return. The hypothetical illustration is for informational and education purposes only and based upon a hypothetical straight-line 5.50% annual growth rate assumption, which is reflective of Neuberger Berman’s moderately aggressive asset allocation model (without alternatives). These hypothetical returns are used for illustrative purposes only. They are not intended to represent, and should not be construed to represent, a prediction of future rates of return. The illustration does not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal.

If desired, spouses of children and grandchildren may be added as donees of the annual exclusion gifts and as beneficiaries of the trusts. By expanding the class of beneficiaries, even greater federal gift and estate tax savings can be achieved.

The transfer tax savings on these gifts can be measured by the federal (and state, if applicable) estate tax rate multiplied by the future value of the gifts in the year of death. Assuming a combined federal and state estate tax rate of 45% (although this rate may be higher in future years) and a future value of the gifts, as set forth above in Year 20, in the amount of $9,229,242, transfer tax savings in the year of death in that year would be $4,153,159. Further, at the end of the 20-year period, the donors will have gifted $9,229,242 to one or more trusts for their heirs, allowing the heirs access to the funds without an associated transfer tax burden, and their exemptions will have been available to offset other transfers.

It should also be noted that annual exclusion gifts can be used to fund 529 plans, which can be established to help individuals save for and pay the costs of education, including college and expenses of qualifying private, public and religious institutions offering a kindergarten-through-12th-grade education. As a bonus, individuals are permitted to “superfund” a contribution to a 529 plan with up to five years of annual exclusions in one year. In 2024, gifts totaling up to $90,000 per beneficiary ($180,000 for married individuals) are allowed to be transferred into such plans.

Payment of Educational and Medical Expenses

Significant transfer-tax savings can also be achieved by taking advantage of the exemption allowed for certain payments for educational and medical expenses. Under current law, any amount paid on behalf of an individual as tuition to an educational organization, or to any provider of medical care with respect to such individual, is not treated as a transfer of property for gift tax purposes. For gifts to qualify under this exception, payments must be made directly to the educational or medical provider. Reimbursements to the individual for these expenses will not qualify.

Given the high cost of private elementary/secondary school and college, meaningful savings can be achieved by paying tuition on behalf of other individuals. Assume that a grandparent has five grandchildren attending college with a tuition of $65,000 per year for four years. Total tuition for each grandchild would be $260,000. Total tuition for all five grandchildren would be $1,300,000. Ignoring the future value of these tuition payments and applying a federal and state estate tax rate of 45%, the transfer-tax savings would be $585,000, and neither the grandparent’s exemption nor annual exclusions would have been consumed.

Conclusion: Benefiting From Existing Transfer Tools

For individuals looking to take advantage of current (and likely future) tax laws, annual exclusion gifts and transfers for educational and medical expenses can yield significant gift and estate transfer-tax savings. In our view, it’s important not to overlook the benefits of establishing and maintaining a regular gifting plan employing these tax tools.