Are lifetime gifts a better idea than making heirs for my estate plan?

There are three types of taxes that warrant consideration when you are deciding between giving away your estate as opposed to allowing it to pass by will. The first kind is the federal gift tax. The second is the federal estate tax. Finally, there are the inheritance taxes that a few states impose.

According to the IRS, the federal tax law allows you to give away $16,000 per person each year to whomever you want without incurring a tax. If you are married, your can each give away $16,000. There is no reduction in the amount you and your spouse can each give just because you are married.

If you give away more than $16,000 to one person in a year, then you must pay the federal gift tax on the amount you gave to that person over $16,000. The gift tax rate ranges from 18% of the excess to 40%. But you won't have to pay that tax right now. The amount given over $16,000 per person becomes a credit to your federal estate tax when you pass away.

Federal law defines certain types of payments to benefit others as not gifts at all. Thus, they do not incur tax consequences regardless of amount. The three primary types of these non-gifts are money paid to to educational organizations, for medical expenses and as political contributions.

If a school - not just a college, it could be an elementary or high school - has a regular curriculum, faculty and body of students, payments you make directly to the school aren't counted as excess gifts provided they are used solely for tuition. For example, you could give your granddaughter $16,000 and then pay tuition for her of $20,000 without incurring gift tax consequences.

Any payments you make over the $16,000 limit for medical expenses or medical insurance are not subject to the gift tax if they are the same kinds of expenses that would be deductible for federal income purposes. You must make the payments directly to the provider, institution or insurance company. Using the same granddaughter as an example, you could pay for her unreimbursed medical expenses without suffering gift tax consequences.

You may give to political organizations without regard to any gift tax limitations. These political organizations include parties, committees, associations, funds or other organizations that exist to fundraise.

For 2022, federal tax law includes an exemption from taxation of $12.06 million for an estate. In other words, if your estate is worth less than that amount, then there will be no estate tax. But there is a caveat. If you have previously given more than $16,000 to any person in a year, then the IRS will count the excess against your exemption.

For example, suppose you give $100,000 to your son. Of that amount $85,000 would be applied against the estate tax exemption of $12.06 million, reducing the exemption to $11.976 million. For this reason, the $12.06 million is sometimes called the “lifetime gift tax exemption.” If you use up your lifetime gift tax exemption, then you will have used up your estate tax exemption, so tax would be imposed at the 18% to 40% rate upon your death.

In addition to federal taxes, some states impose inheritance or gift taxes. The rules among these states vary on how much of the estate is exempt, what the tax rate is, and who must pay the tax. Those states include Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. If you live in one of those states, or if the person you are giving to lives in one of them, you should consult that state's law to learn about the inheritance tax in that state.

If you are thinking about making gifts to family members who might be beneficiaries of your will, a factor to consider is whether making those gifts would help lead to family harmony. The most bitter family fights that arise are over a decedent's estate. These fights involve not only who should be in charge, but how much money various beneficiaries should receive and how personal property of sentimental value should be divided.

You can avoid some of these issues by making gifts to your family and others while you are still alive. For example, if you make gifts of money, you can ensure that everyone similarly situated receives the same amount, or if not, have the chance to explain why your giving was disproportionate. For example, if one of your loved ones is handicapped, you could gift money into a trust and let others know the reason for that gift. Finally, personal objects often either no longer exist or cannot be found upon death. By giving them away during your lifetime, you can make sure that the person you have selected actually receives the gift.

In addition to the pleasure one feels when making a gift to another, there are some practical aspects of making gifts. For example, suppose you give a college student $16,000 but he fritters it away on parties and a car that is subsequently repossessed. You know that he is not ready for gifts at this time, so a testamentary gift or trust might be the better way to take care of him.

Another situation can arise where you both give money to a grandchild and, for example, pay tuition to the child's school. If the student does well, you have spent your money wisely and can take pride in the grandchild's achievements. But if the child is lackadaisical in school, then perhaps now is not the time to be giving gifts.

The pros and cons of gifting over leaving property by will come down to three things. First, unless you are wealthy to the extent that you have an estate worth $12.06 million, you will not encounter any gift or estate tax consequences whichever route you choose. Second, if you try gifting money instead of leaving it posthumously, you can exercise control over the amounts and timing of gifts should your recipients turn out to be irresponsible with money. Finally, if you make gifts, you can enjoy the emotional rewards of helping others and appreciating their achievements should they use your gifts in a responsible way. The choices are yours.