Financial PlanningUnderstanding Gifting Rules Before the Sunset

Financial planning can be challenging in a world where rules change constantly.

For many families with significant wealth, estate planning just got more complicated.

As the expiration of the Tax Cuts and Jobs Act (TCJA) approaches in 2025, the lifetime exclusion amount for gifting will be reduced going forward. The total allowance will roughly be cut in half.

The expiration of this tax provision will have an impact on overall gifting strategies and estate planning decisions that are being made today. Failure to take action before the end of 2025 may have a significant impact on the amount of assets that can be left to the next generation.

How should high earners think about gifting?

Currently, individuals can shelter $12 million of their wealth over their lifetime from federal gift and estate taxes – referred to as the lifetime exclusion. Remember that this is in addition to the annual gift exclusion ($16,000 for 2022). Gifts made in excess of the annual limit are considered taxable gifts and will reduce the lifetime exclusion amount.

With the sunset of most of the provisions within the TCJA, this lifetime exclusion figure is projected to decrease to roughly $6.5 million beginning in 2026.

For those who haven’t utilized the lifetime exclusion, they risk losing the ability to shelter this higher amount of wealth at the end of 2025.

This can have a profound impact on how much wealth can be transferred to heirs considering the 40% federal gift and estate tax rate.

In fact, discussions within Congress last fall focused on reducing the lifetime exclusion much earlier — at the beginning of 2022. While this provision was eventually abandoned, planning strategies should be considered and analyzed well before the 2025 sunset occurs.

Gifting tax rules are set to shift in 2026

gift and estate tax exemption current and in 2026

Understanding how taxable gifts are applied against the lifetime exclusion amount*

During my travels speaking to financial advisors and their clients, there’s often some misconception on details of the sunset provision and how gifts made today impact the lifetime exclusion amount.

Most investors understand that the reduction in the exclusion amount after 2025 represents a “use it or lose it” proposition.

However, many advisors and clients are not aware of how ordering rules apply to current taxable gifts, and how they impact the lifetime exclusion amount.

If a gifting strategy is not pursued between now and the end of 2025, these clients will miss out on sheltering the amount between the current exclusion ($12 million) and the projected exclusion amount in 2026 ($6.5 million).

Before pursuing a gifting strategy to take advantage of the higher exclusion amount before it lapses, it’s important to understand how gifts today are applied against the lifetime exclusion amount, specifically how ordering rules apply.

  • Beginning in 2018, the TCJA doubled the lifetime gift and estate exclusion (from $5 million adjusted for inflation to $10 million adjusted for inflation)
  • Think of the amount of the estate and gift tax exclusion in place prior to the TCJA as the “original” exclusion amount ($5 million adjusted for inflation) and the amount of the increase in the exclusion due to the TCJA as the “additional” exclusion amount
  • Some may think that gifting the amount that will expire at the end of 2025 — the “additional amount” — will preserve the higher exclusion amount introduced by the TCJA before it expires
  • However, gifts above the annual exclusion amount ($16,000 per individual for 2022) are applied first to the “original” exclusion amount, that is, the amount that existed prior to the TCJA
  • To utilize the higher exclusion amount before it expires, an individual has to gift more than the amount of the gift and estate tax exclusion in place prior to the TCJA
  • Only then will there be a benefit from utilizing the additional exclusion amount introduced by the TCJA before it expires in 2025
Consider this example
  •  John has not previously made any taxable gifts, so his lifetime gift and estate tax exclusion is $12 million
  • We assume the lifetime exclusion will be $6.5 million beginning in 2026 once the sunset provision takes effect
  • He is concerned that after 2025 he will lose the ability to shelter $5.5 million in wealth due to the sunset provision
  • He decides to make a taxable gift of $8 million in 2022
  • The first $6.5 million of the gift made is applied against the “original” exclusion amount, that is, the amount that existed prior to the TCJA – essentially you use up the exclusion amount that does not sunset in 2025 before applying taxable gifts to the portion of the exclusion amount that does expire in 2025
  • The rest of the gift ($1.5 million) is applied toward the “additional” exclusion amount, the increase due to the TCJA, which expires at the end of 2025
  • In this case, John has benefitted from sheltering $1.5 million from federal gift and estate taxes prior to the reduction in the exclusion amount due to the sunset provision
  • Assuming the sunset provision applies in 2025 and John does not make any subsequent lifetime gifts, his lifetime exclusion amount beginning in 2026 will be zero
  • Failure to understand these ordering rules may adversely impact planning
Seek professional advice

Before acting on a gifting strategy, individuals need to understand how the sunset provision of the estate and gift tax under the TCJA impacts gifting and the ordering rules. It is important to consult with a professional advisor for expert guidance on how to optimize the gift for the maximal tax benefit, prior to 2025. It’s also important to engage in discussion well in advance of the expiration date, and realize that tax law changes could occur before the sunset provision takes place.

 

*Department of the Treasury, Estate and Gift Taxes; Difference in the Basic Exclusion Amount, Final Regulations, November 2019.

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 Securities offered through “LPL Financial”, member FINRA/SIPC.

The above material was prepared by Putnam Investments.

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Sonya Jones

I endeavor to provide excellent service to our clients and organizing processes and procedures to ensure our office runs smoothly. When not working, I enjoy spending time with my fiancé, Erik, and our two boys, Lukas and Archer along with our dog Pixie. I love cooking for them and experimenting with different recipes and techniques, including treats for Pixie. Our favorite family activity is taking road trips, especially to California to visit family and friends.

Education and Biography

TRAINING
Sonya received her BA in Art at California State University, Chico and has over 25 years of administrative and customer service experience in the financial services and accounting industries.

SPECIALISMS
Sonya’s focus is to help clients reach their financial goals by assisting them with their various transactions and paperwork to service and maintain their accounts. This includes opening new accounts and initiating transfers from and to financial institutions. Sonya is constantly looking for new ways to improve our processes to ensure we work efficiently and in a manner that creatives positive experiences for our clients.