Annual Exclusion: What It Is, How It Works, and Examples
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Summary:
The annual exclusion allows individuals to make tax-free gifts up to a certain amount each year. Learn how it works, its implications on estate taxes, and more.
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What is an annual exclusion?
An annual exclusion is the amount of money that one person may transfer to another as a gift without incurring a gift tax or affecting the unified credit. This annual gift exclusion can be transferred in the form of cash or other assets. The Internal Revenue Service (IRS) announced the annual exclusion will increase to $17,000 in 2023 (up from $16,000 in 2022).
How annual exclusions work
The annual exclusion applies per person, per year. If grandparents gift several thousand dollars to each of their grandchildren, each amount will be considered separately toward its own annual exclusion.
The year resets and restarts on Jan. 1. You could give a single individual $16,000 on Dec. 31, 2022, and $17,000 on Jan. 1, 2023, because this is a new year with a higher exclusion. All gifts made to the same individual count toward the exclusion.
While any gift is generally a taxable gift, exceptions do exist. For example, the following gifts are not taxable:
- Gifts that are less than the year’s annual exclusion
- Tuition or medical expenses
- Gifts to a spouse
- Gifts to a political organization
Gifts to qualifying charities are also deductible from the value of the gift(s) made. Otherwise, taxpayers cannot deduct the value of gifts they make. IRS Publication 559, Survivors, Executors, and Administrators lays out the specifics in this regard.
Special considerations
The annual exclusion plays a key role in estate tax exemption and wealth management.
Estate tax exemption
The $17,000 annual exclusion means you can give $17,000 to as many people as you want. So you can give each of your five grandchildren $17,000 apiece in a given year, for a total of $85,000. Any gifts you make to a single person over $17,000 count toward your combined estate and gift tax exclusion. This is the amount you are allowed to leave in your estate or give as gifts during your life tax-free.
For 2022, the lifetime gift tax exemption is $12.06 million (increasing to $12.92 million in 2023). This means that if you are married, you and your spouse can give away a total of $24.12 million (increasing to $25.84 million in 2023) before paying the gift tax.
These new exemption thresholds were established by the Tax Cuts and Jobs Act (TCJA), which expires in 2025. The TCJA more than doubled the federal estate and gift tax exemption, which was previously $5 million (adjusted annually for inflation).
Wealth management
Annual exclusion and estate tax exemption are often considered as part of a larger wealth management plan or estate plan. A high-net-worth individual (HNWI), for example, could enlist the support of a wealth management firm or independent financial advisor to determine how best to allocate financial and other assets via gifts or in a will to avoid heavy tax penalties.
A will is a legal document that provides clear instructions on how an individual’s property and custody of minor children, if any, should be handled after death. In a will, an individual expresses their wishes and names a trustee or executor to fulfill the stated intentions. The will can also indicate whether a trust should be created after death. If a will includes instructions on gifts, this section will determine any tax liabilities for the estate or beneficiaries.
Comprehensive examples
Let’s delve into some detailed examples to better understand the practical applications of the annual exclusion:
Example 1: Maximizing family gifting
Meet Sarah, a mother of three and a grandmother to five. In 2023, she wants to make the most of the annual exclusion. She can gift $17,000 to each of her children and $17,000 to each of her grandchildren without incurring gift tax. Here’s how it works:
- Sarah gifts $17,000 to Child A
- Sarah gifts $17,000 to Child B
- Sarah gifts $17,000 to Child C
- Sarah gifts $17,000 to Grandchild X
- Sarah gifts $17,000 to Grandchild Y
- Sarah gifts $17,000 to Grandchild Z
That totals $17,000 x 3 (children) + $17,000 x 3 (grandchildren) = $102,000 in tax-free gifts in a single year.
Example 2: Charitable giving
Consider Mark, a philanthropist passionate about supporting charitable causes. In 2023, he decides to make substantial gifts to his favorite charities. He can gift up to $17,000 to each of the charities he supports without triggering gift tax.
Understanding the annual exclusion limits
It’s important to be aware of the specific limits and changes associated with the annual exclusion. These limits can impact your gifting strategy and tax planning. Here’s a breakdown:
Annual exclusion for 2023
In 2023, the annual exclusion amount is set at $17,000. This means you can give up to $17,000 to as many individuals as you wish without incurring gift tax. The year resets on January 1, allowing you to take advantage of the updated exclusion limit.
Lifetime gift tax exemption
For 2023, the lifetime gift tax exemption is $12.92 million. This exemption threshold allows you to make cumulative tax-free gifts throughout your lifetime. If you are married, you and your spouse can jointly give away up to $25.84 million before facing gift tax. It’s important to note that this threshold may change in the future due to tax laws and regulations.
Conclusion
The annual exclusion is a valuable tool for individuals looking to transfer assets to their loved ones without incurring gift taxes. Understanding how it works, its implications on estate taxes, and the exceptions to taxable gifts can help you make informed financial decisions. Whether you’re planning to provide financial support to family members or engage in comprehensive wealth management, the annual exclusion is a critical component of your strategy. Keep an eye on the annual exclusion amount, as it can change from year to year, impacting your ability to make tax-free gifts. Consulting with a financial advisor or estate planning professional can help you make the most of the annual exclusion and plan for your financial future.
Frequently asked questions
Is the annual exclusion the same for everyone?
No, the annual exclusion amount can change from year to year. It’s not a fixed amount and may vary based on inflation and tax law changes. In 2022, it was $16,000, but it will increase to $17,000 in 2023. Different years may have different exclusion limits.
Can I give the annual exclusion amount to multiple individuals?
Yes, you can give the annual exclusion amount to as many people as you want, not just one individual. For example, if the annual exclusion is $17,000, you can give $17,000 each to multiple recipients without incurring gift tax. This allows you to distribute your gifts more broadly.
Are there any exceptions to taxable gifts?
Yes, there are exceptions to taxable gifts. For example, gifts that are less than the year’s annual exclusion are not taxable. Additionally, gifts for tuition or medical expenses, gifts to a spouse, and gifts to a political organization are generally not subject to gift tax. Gifts to qualifying charities are also deductible from the value of the gift.
What happens to the annual exclusion if I exceed the limit for a single person?
If you exceed the annual exclusion limit for a single person, the excess amount may be subject to gift tax. For example, if the exclusion is $17,000, and you gift someone $20,000, the extra $3,000 may be subject to gift tax. It’s important to keep track of your gifts to avoid exceeding the limit.
How can the annual exclusion impact my estate tax planning?
The annual exclusion is closely related to estate tax planning. It allows you to make tax-free gifts during your lifetime, reducing the value of your taxable estate. By taking advantage of the annual exclusion, you can pass on assets to your loved ones without incurring gift or estate taxes, ultimately preserving more of your wealth for future generations.
Key takeaways
- An annual exclusion amount is how much a person can transfer to another without paying a gift tax.
- For 2022, the annual exclusion amount is $16,000 (increasing to $17,000 in 2023).
- The $17,000 annual exclusion means you can give $17,000 each to as many people as you want, not just one individual total.
- For 2022, the lifetime gift tax exemption is $12.06 million (increasing to $12.92 million in 2023).
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