Financial gifting to family members can be a double-edged sword. While it’s a generous way to support loved ones, concerns about enabling irresponsible behavior and navigating complex tax laws can add stress to the process. Many individuals hesitate to offer financial assistance knowing that a portion will be claimed by taxes.
However, there’s immense satisfaction in helping family members overcome financial challenges or achieve significant milestones, such as funding education or homeownership, or providing support to elderly parents.
If you’re considering giving money to family, it’s essential to understand the implications and explore strategies to ensure your gift is utilized effectively and doesn’t incur excessive taxation.
Avoiding the Gift Tax
One peculiar aspect of the U.S. tax code is the potential tax burden on large financial gifts, which can reach as high as 40%. Consider this: if someone like your aunt decides to give her grandson $20,000 to assist him, she might face a tax bill of $8,000.
This scenario understandably deters many from giving money away, especially when considering the hassle of meticulously tracking every dollar gifted. To address this, the IRS established a rule specifically for such gifts. Individuals are allowed to gift a certain amount of money each year without triggering the gift tax. This threshold is regularly adjusted for inflation. As of 2021, the annual gift exclusion amount is $15,000 per person, offering a tax-free option for financial assistance.
Loopholes and Limits
This implies that you can give up to $15,000 annually to each individual (or $30,000 for married couples) without incurring any tax liability to the IRS. Returning to my example, my aunt could still gift $20,000 to her grandson. However, she could claim she’s giving him $10,000, while my uncle gifts the remaining half. Moreover, they could likely give him more. Here’s why: the grandson, who is an adult married with two children, allows my aunt and uncle to directly gift him $30,000, another $30,000 to his wife, and equal gifts to both children. This totals $120,000 in gifts without drawing IRS attention.
Once the grandson’s family receives the cash, they can manage expenses by dividing each bill among themselves.
It’s essential to highlight the existence of a lifetime gift tax exemption. Suppose I give $50,000 to my single cousin. In that case, I wouldn’t owe any taxes because my wife and I can collectively gift him $30,000, with the remaining $20,000 applied toward my lifetime exemption. While I would need to file a gift tax return, I wouldn’t need to pay taxes for being generous. For 2021, the lifetime gift tax exclusion stands at $11.7 million. However, depending on inflation, this limit may decrease to around $5 million by 2026.
Make Sure Money Goes To Where You Intend
One straightforward method to sidestep the gift tax is by covering the educational or medical expenses of your loved ones. You can spend an unlimited amount on these costs without facing any tax penalties. Simply direct the funds to the institution where the expense was incurred. This not only ensures that your money is used as intended but also avoids it being spent indiscriminately by the recipient. Be sure to retain your receipts and records in case the IRS requests proof.
If you aim to assist with a young relative’s education expenses, you can also contribute to a 529 account for them. While these contributions are considered gifts by the IRS, you can deposit up to $75,000 (or $150,000 for married couples) into a 529 account for one beneficiary in a single lump sum. This contribution is treated as if it were five separate $15,000 gifts spread over five years. Consequently, you cannot provide additional funds to the 529 beneficiary during that period without triggering the gift tax. Nonetheless, it presents an excellent opportunity to financially support your relatives while circumventing unnecessary taxes.
What About Loans?
If you found gifting money to be complex, brace yourself for the intricacies of lending rules. When you lend money to someone, you’re obligated to pay taxes on the interest you should theoretically charge, even if you opt not to charge any interest at all. Enter the IRS’s “below-market interest rule,” which mandates calculating hypothetical interest payments from the borrower. If these interest payments surpass the annual gift tax threshold (which was $15,000 in 2021), you must report that interest income on your tax return and pay taxes on it.
But wait, there’s more. The IRS provides an Applicable Federal Rate (AFR) table, dictating that any loan you extend must charge at least the specified interest rate or higher. To add another layer of complexity, different rates apply to short-term, mid-term, and long-term loans, all tied to the bond market. Fortunately, the AFR is currently relatively low. As of now, the short-term rate hovers around 1.60%, with a long-term rate of approximately 2.07%.
Before offering an interest-free loan, think twice. In many cases, it’s simpler to impose a nominal interest rate. Alternatively, consider gifting the entire amount instead.
In Conclusion
Gifts of money should ideally be beneficial for both the giver and the recipient. The giver experiences the satisfaction of helping a loved one while the recipient gains the opportunity to enhance their financial circumstances. Therefore, when considering a substantial monetary gift for a family member or friend, thorough research is essential. Take the necessary time to strategize how to maximize the gift without encountering hefty tax implications. Ensure all logistical and operational details are ironed out before discussing the gift with the potential recipient. Adjusting a promised gift due to tax considerations can unnecessarily complicate matters, making proactive planning crucial.