Gift tax exclusion keeps on giving

FCW.com's Friday Financials column shows how the increase in the gift tax exclusion is a good benefit

The annual $10,000 gift tax exclusion will increase to $11,000 this year, and anyone who has an estate vulnerable to estate taxes or who is funding high-cost college expenses should consider using this exclusion.

This often-overlooked exclusion allows you to give away a certain amount each year per person without being subject to gift tax. Although the exclusion amount was indexed for inflation starting in 1997, it hadn't changed because inflation has been low and the amount can increase only in $1,000 increments. However, the exclusion finally jumps to $11,000 ($22,000 for couples) for 2002.

Many taxpayers may say, "so what," now that the Tax Relief Act dramatically raises the exemption amount for gift and estate taxes, beginning this year. The lifetime gift exemption jumps to $1 million in 2002, and the estate tax starts at $1 million and rises to $3.5 million by 2009. Estate taxes are scheduled to be fully repealed in 2010.

Despite the changes, the annual gift tax exclusion still serves a useful purpose in many cases.

First, said Dennis Filangeri, a certified financial planner in San Diego, keep in mind that estate taxes will continue to be imposed until 2010, and then the estate tax will be fully repealed for only one year. It's reimposed starting in 2011 unless Congress passes new legislation to continue the repeal. Consequently, reducing the size of tax-vulnerable estates remains important.

Filangeri offers this example: Bill dies in 2009 with a $3.5 million estate. That amount normally would be exempt from estate taxes under the current schedule. However, Bill made taxable gifts of $1 million during his lifetime to his three children and three grandchildren. Now, only $2.5 million would be exempt from estate taxes, leaving $1 million exposed to estate taxes. By using the new $11,000 annual exclusion amount, Bill and his spouse could reduce that exposure by annually giving away a total of $132,000 a year to their heirs.

The benefits could be even greater by donating appreciating assets. A couple might give away $22,000 in growth stocks to a child, which the child might later be able to sell for $55,000 (on which the child would pay capital gains tax). Not only is the $22,000 out of the parent's estate, so are the $33,000 in subsequent gains.

Second, under the Tax Relief Act, the lifetime gift-tax exemption remains fixed at $1 million, unindexed for inflation, and it is scheduled to continue even after the estate tax is repealed. Any lifetime gifting that exceeds the $1 million threshold will be subject to tax, even if the estate-tax exemption is higher than that amount.

Consequently, the annual gift tax exclusion will be valuable should you want to give away more than $1 million during your lifetime. Furthermore, because the annual exclusion is indexed, the dollar amount will increase faster and faster over time.

The increase to $11,000 also will help taxpayers funding Section 529 college savings plan and state prepaid tuition plans. Says Filangeri: Currently, someone can put up to $50,000 into one of these plans (or $100,000 as a couple) at one time because the government allows you to count it as five years' worth of $10,000 annual gifts. The increase to $11,000 will allow you to bump your contribution up to $55,000, or $110,000 per couple.

Keep in mind that you can contribute, tax free, an unlimited amount on behalf of a person if that gift goes directly to an educational organization to pay for tuition (not through the person benefiting from the payment) or to a health-care provider for qualified medical services. Thus, a grandparent could pay a grandchild's annual $20,000 tuition bill without any of the gift counting toward the $1 million lifetime exemption -- and could still make another annual $11,000 gift directly to the child gift-tax free.

Zall is a retired federal employee who since 1987 has written the Bureaucratus column for Federal Computer Week. He can be reached at milt.zall@verizon.net.

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