The Power of Lifetime Gifting

Giving assets to children or grandchildren during your lifetime can be more than a generous gesture. Given the right circumstances, gifts may also reduce the federal estate tax, move future growth outside your taxable estate, and help younger generations when it can make the greatest practical difference.

In this article, we discuss some benefits of lifetime gifting using simple examples under the federal estate and gift tax laws. These examples do not account for state estate tax and gift tax rules and do not account for variations in deductions, types of assets, variations in investment returns, etc. Additionally, note that lifetime and post-death gifts subject to federal transfer tax are subject to a gift tax of 40%.

A Simple Starting Point

Lifetime gifts can be appealing because a gift-tax payment may itself remove value from the taxable estate. Put differently, if a donor pays gift tax while alive, the estate generally does not later include the dollars used to make that tax payment. That can make a lifetime transfer more tax-efficient than retaining the same assets until death. In comparison, the estate tax is imposed on all assets owned at death. So, a donor is taxed not just on the value of the gift, but also on the money used to pay the estate tax. A gift during life avoids this extra tax.

Example 1: Paying Transfer Tax During Life Can Shrink the Taxable Estate at Death

Assume a person has already used all of their federal unified exemption amount (currently a total of $15 million available to give during life and after death). This donor wants to make a gift of $5 million to another, non-spouse individual. At a 40% tax rate, the donor will owe $2 million in tax. In this case, a total of $7 million is removed from that donor's estate. Now compare that with keeping the gifted amount and the tax paid. If the $5 million is not gifted and the $2 million that otherwise would have been paid as gift tax also remains in the estate, $7 million remains subject to estate tax at death (assuming no losses or appreciation). This will result in $2.8 million in tax, which is an $800,000 increase over the tax that would have been paid if the gift were made during life.

Example 2: Save Transfer Tax on Future Appreciation

The first example treats the numbers as though they never change. Realistically, assets often appreciate in value over time.

Using the common financial rule of thumb that an investment tends to double about every seven years, assume the $5 million is retained rather than gifted. When the donor dies 15 years later, the asset has increased in value to $20 million (those $5 million of assets doubled to $10 million and then doubled again to $20 million), which is now part of the taxable estate. At the 40% rate, the resulting estate tax would be approximately $8 million, four times higher than the $2 million gift-tax payment. By making the gift during life, the donor was able to avoid $6 million in taxes.

Example 3: Using Irrevocable Trusts to Move Growth Outside an Estate

A lifetime gift does not always have to be made outright. A donor may instead transfer assets to a properly structured irrevocable trust for their beneficiary.

When a completed transfer is made to an irrevocable trust and the trust is structured so that its assets are not includible in the beneficiary's taxable estate, the future appreciation on the transferred property can remain outside that beneficiary's estate as well. That distinction may be significant for an asset that is rapidly appreciating: the tax planning may apply not only to the original $5 million, but also to its future growth.

While gifting to irrevocable trusts has benefits, it is not without drawbacks. There are initial and ongoing administration and transaction costs; therefore, one consideration is the willingness to donate enough to make the trust "worth it" from the outset.

The trust's terms, who will act as trustee, the beneficiary's rights and powers, and applicable state law are just a few of the other factors that need consideration when establishing or deciding to establish an irrevocable trust.

Lifetime Gifts Can Matter Even When Exemption Remains

The case for lifetime giving is not limited to donors who have used their federal exemption or are making gifts in multiples of millions. A gift could actually be particularly meaningful when the recipient is young and has not yet had time to build wealth.

For example, a lifetime gift might help a child or grandchild:

• Make a down payment on a first home;
• Pay down or pay off a home mortgage;
• Pay college tuition or other education costs; or
• Begin investing earlier in adulthood.

Early assistance can change the recipient's financial trajectory in life. A down payment may allow someone to become a homeowner sooner. Paying tuition or reducing mortgage debt may free monthly cash flow for savings, retirement contributions, or other investments. And money invested earlier has more time to grow and multiply. In short, the same dollar may have greater practical value when it is received at a stage of life when it helps a beneficiary establish financial stability, rather than years later as an inheritance.

Important Considerations to Remember Before Gifting

Investments do not always grow at the same rate, and they can also decline in value. The potential growth of an asset (not just its value on the day of the gift) can be central to a gifting decision. And, of course, a person considering lifetime gifting should retain sufficient resources for their own personal needs and wishes. Additionally, most gifts to a non-spouse that exceed the annual exclusion amount (currently $19,000) require filing a gift tax return.

Another important tradeoff is income tax basis. Property received by gift generally carries the donor's basis, while property inherited at death typically receives a basis adjustment at death. That difference can affect future capital gains tax if the recipient later sells the asset. Therefore, a complete analysis considers both transfer tax savings and possible income tax consequences.

The Takeaway

Lifetime gifting can allow families to move assets—and potentially all future appreciation on those assets—out of a taxable estate while helping beneficiaries at a time when the assistance may be especially useful. The potential benefits are often strongest when gifts are made early, when assets are expected to appreciate, and when the donor can comfortably part with the property. If you are considering lifetime gifts, a great starting point is discussing gifting options with your attorney or your accountant.