Most of the time this blog addresses how to keep more of your money. Today is about the opposite: how to give it away. While making smaller, ordinary gifts isn’t necessarily complicated, when making significant gifts, either now or after your death, if you’re not careful with who’s getting what, the tax man will have his hand out too while you’re passing out the gifts. Sometimes that’s unavoidable, but planning can keep him from getting on your list of recipients uninvited. Please note as always, these are general guidelines and you should discuss your individual situation with your tax and legal advisors.
Giving in Life
It’s nice to think of leaving something behind for your family or favorite charity after your gone if you can, but it’s also nice to do your giving while you’re living so you’re knowing where it’s going. Whether you make it possible for your grandchildren go to college, help your kids buy their first house, or invest in your community, seeing the good that can come from the money you worked hard to earn all your life can be very enjoyable.
A common question asked by the lucky ones who are receiving a gift is, “will we need to pay taxes on it?” The answer to that is no- you won’t. However, whoever is giving you the gift may have some paperwork to take care of, and in rare instances, some tax to pay. Under current tax law, the annual gift tax exclusion amount is $14,000. That means that you can gift any one individual up to $14,000 total in one calendar year without filing a gift tax return. For a married couple, one spouse can use the other’s exemption also and gift up to $28,000, but must file a gift tax return showing the split gift (non-citizens have entirely different rules). So what is the tax on a gift over $14,000? When you file your gift tax return (Form 709), the amount of gifts you made in excess of the exemption amount is subtracted from your lifetime gift exclusion, which currently stands at $5.25 million, less any gifts you reported in prior years. As long as you have some of your lifetime gift exclusion left, no tax is currently due. It does reduce your estate tax exemption as well, so should your estate reach those levels it may become a tax issue at your death.
Gifting to a charity does not require filing a gift tax return, and in fact, as I’m sure you know, may result in a tax savings for you. But where that money comes from that you wish to donate can have unintended tax consequences that can end up costing you money. Let’s say the bulk of your money is in your Traditional IRA account, and you would like to donate a nice chunk of it to your favorite qualified charity. But that good feeling you had when you gave the money might disappear when April 15 rolls around. Why? Isn’t it an even trade- a withdrawal from the IRA for a charitable deduction? Technically yes, but other things come into play. Your IRA withdrawal will be added to your adjusted gross income, which affects how much of your Social Security is taxed, how much of your medical expenses and miscellaneous itemized deductions are allowable, and if it’s large enough can increase your Medicare Part B premiums or subject your other investment income to the new 3.8% surtax. Ouch.
At least through the end of 2013, there is a way to make a donation from your IRA though, and bypass the potential tax trouble. For those age 70 ½ or older, you can rollover funds from your IRA directly to a qualified charity. This Qualified Charitable Distribution, which can be up to $100,000, can even be used to satisfy your required minimum distribution.
Not 70 ½ yet? You can take advantage of gifting highly appreciated assets. Maybe you have some stock that you paid $500 for years ago, now worth $10,000. If you sell it and gift the money, you could end up with those unintended adjusted gross income issues again, on top of any capital gains tax due on your $9,500 gain. Instead, you can donate the stock intact (without selling it) to a qualified charity and, depending on your tax situation, may be able to deduct the full fair market value of $10,000.
You can also gift that stock to an individual, and while you won’t get a tax deduction, you also won’t have to pay tax on the gain. That will now be up to the person you gave it to. The recipient will have a basis in the stock equal to what your basis was (basis being the amount you have into the stock between purchases and dividend reinvestments). So when he sells, he will recognize that $9,500 capital gain, not you.
Giving after death
Looking at that same stock, if you wait and leave that through your will, it will get what’s called a “step up” in basis. So whatever it is worth when you die (or an alternate valuation date), is now the basis your heir will use in calculating capital gain. If he sells pretty quickly, there likely will be little gain to be taxed. However, he won’t get off that easy, because we need to consider inheritance tax, which would not have mattered had you gifted the stock more than one year before dying. When deciding when to leave assets, whether before or after death, you may want to weigh the recipient’s income tax vs the inheritance tax burden.
Other than the inheritance tax, leaving those highly appreciated assets like stocks is pretty tax efficient, with your heirs keeping most of what you’re gifting. But leaving IRA assets to your kids? Not as efficient. Money inherited via an IRA is considered Income in Respect of a Decedent, and when your beneficiary takes a distribution, he is taxed at on it like other ordinary income. At best, if the IRA is small enough, or if he takes the minimum that can be distributed each year, he may pay tax on it at his current marginal tax rate. But depending on the amount of the distribution, he might be pushed into a higher tax bracket, have deductions or credits limited, or deal with the adjusted gross income issues we mentioned above- not to mention the inheritance tax that may be due. Soon the amount he nets is not nearly as much as you left. Naming a charity as beneficiary of your IRA and leaving other assets to your children (and not the other way around) is much more tax efficient. Life insurance, for instance, will not have an impact on the beneficiary’s income taxes, and is not subject to inheritance tax (all of these scenarios assume federal estate tax is not a factor). Should you wish to name a charity as beneficiary of your IRA, it’s simplest for the charity to be the sole beneficiary of the account. It is possible to name a charity as one of multiple beneficiaries but special care must be taken with distributions after your death.
Naturally more goes into decisions like these than just tax considerations and how the numbers play out. Contemplating your mortality and what happens to your “stuff” after you’re gone can be emotional. But taking time to keep the IRS out of your estate unnecessarily can ensure that the legacy you leave, at least through your financial assets, will have as much of an impact as possible.