Making Gifts Before They Become Tax Exempt Can Save You Money

Estate Planner Nov-Dec 1997

On Jan. 1, 1998, the Taxpayer Relief Act of 1997 begins phasing in an estate and gift tax unified credit equivalent increase, from the current $600,000 to $1 million, according to the following schedule:

Changes in Gift and Estate Tax Exemption Equivalent

1998 $625,000
1999 $650,000
2000 & 2001 $675,000
2002 & 2003 $700,000
2004 $850,000
2005 $950,000
2006 $1,000,000

This tax law change is good news for those with substantial estates and those who have already used up their $600,000 exemptions. These individuals can now transfer additional amounts without incurring gift or estate taxes.

Against this backdrop, let’s examine why financial planners have been trying to persuade their older and wealthier clients to make taxable gifts in excess of the exemption amount and pay a gift tax.

Gift Taxes Are Less Expensive Than Estate Taxes

The mathematics can prove that writing a check for gift taxes, as painful as it may seem at the moment, will probably save your family a lot of estate taxes, provided you survive for at least three years after the date of the gift.

This is true because 1) a current gift removes future appreciation on the assets given away from your estate, and 2) gift tax rates are effectively lower than estate tax rates because tax is paid only on the amount of the transfer itself, not also on the amount of the tax.

The latter point is illustrated by the over-simplified example on the next page, which shows that the children get to keep two-thirds of the total funds when they receive a gift, but only half of the total funds when they inherit them.

Making Taxable Gifts Under the New Law

Now, let’s look at what happens when an individual has given away or will give away the current exemption amount of $600,000 and is willing to give away an additional amount of up to $400,000 (double both amounts for a married couple). Should the gift be made in 1997 before the exemption amount begins to increase or in annual increments as the exemption increases to $1 million?

The chart below assumes a fund of $553,000 (the amount necessary to make a $400,000 gift, plus pay the gift tax), a 6% after-income-tax investment rate of return, and the maximum estate tax rate of 55% for an individual who has already used the $600,000 exemption. It compares three scenarios:

a. No additional gifts,
b. An additional $400,000 gift spread over a period of years coinciding with the exemption increases, and
c. An additional 1997 $400,000 taxable gift.

The results show that doing nothing clearly is not the best course of action. The figures also show that if an individual makes the 1997 gift of $400,000 and lives for 10 years, his or her heirs will receive roughly $143,000 more than if the individual makes the same gifts gradually as the exemption increases.

Act Now To Reap Maximum Benefits

Is this strategy right for you? First ask whether you can afford to part with the funds (the gift plus the tax) needed to implement such a strategy. If you can, analyze your situation, including your age, projected estate tax bracket, projected investment rate of return and other available planning opportunities. You can then decide if you are ready to take what may seem a bold step but will actually be a smart move. The opportunity will slowly begin to slip away Jan. 1, 1998, so let us know if we can help you choose the best course of action for your situation.

Gift No Gift
Gross amount of funds used $1,500,000 $1,500,000
Amount of gift (1,000,000)
Gift tax (500,000)
Amount taxed at death 1,500,000
Estate tax (750,000)
Net to heirs $1,000,000 $750,000
Percent to heirs 66.67% 50%