Some people worry that offering financial help will enable irresponsible family members. On top of that, complicated tax laws can make the whole process much more complicated than it needs to be. Who wants to give their kids money knowing that Uncle Sam is going to demand a chunk of it? That’s why financial gifting can be stressful, even for those wanting to offer the help.
On the other hand, giving money to family is a great way to enjoy the fruits of your labor. If you can afford it, there’s real value in seeing your struggling loved ones get back on their feet. Or giving your children a bit of a head start when it comes to college or buying their first house. Or helping out your elderly parents.
Are you thinking of giving money to family? Here is what you need to know, along with the best ways to ensure that your money is well-spent and not taxed like crazy.
Avoiding the Gift Tax
One of the strangest aspects of the U.S. tax code is that the giver of a large financial gift can owe as much as 40% of the money in taxes. This sounds really bad. For example, if my aunt wanted to give $20,000 to her grandson to help him out, she could be on the hook for $8,000 in taxes.
It’s easy to see how this would discourage anyone from ever giving money away. That’s not even mentioning the nightmare of keeping track of every penny you might give. So the IRS made a rule specifically for this kind of gift. They will allow you to gift a certain amount of money every year without incurring the gift tax. That amount is adjusted for inflation regularly. In 2021, you can gift $15,000 per person (per year) without worrying about gift taxes.
Loopholes and Limits
This means that you can give away $15,000 every single year (and $30,000 for married couples) to as many individuals as you like without owing the IRS a dime. Going back to my example, my aunt could still give that $20,000 to her grandson. However, she should just claims that she’s giving him $10,000, while my uncle gifts the other half. In fact, they could likely gift him more. You see, the grandson is actually an adult who is married with two kids. My aunt and uncle could give him $30,000 directly, give his wife another $30,00, and equal gifts to both children. That’s a $120,000 total gift without the IRS batting an eye.
Once the grandson’s family receive all the cash, they can pay for whatever they need by splitting each bill four ways.
It’s also important to note that there’s a lifetime gift tax exemption. For example, let’s say I give $50,000 to my cousin, who is single. I still won’t owe any taxes because my wife and I can give him $30,000, and I can claim $20,000 towards my lifetime exemption. I would have to file a gift tax return. However, at least I wouldn’t have to pay Uncle Sam just for being generous. For 2021, the lifetime gift tax exclusion amount is $11.7 million. However, the limit will probably go down to the $5 million range, depending on inflation, by 2026.
Make Sure Money Goes To Where You Intend
One easy way to avoid the gift tax is to simply pay for the educational or medical expenses of your loved ones. You are legally allowed to spend an unlimited amount of money on these expenses without tax penalty. All you have to do is send the money directly to the institution where the expense was incurred. This also makes certain that your money is used in a way that you intend, rather than simply being spent willy-nilly by the recipient. Make sure you keep your receipts and records, in case the IRS wants proof.
If you are hoping to help pay for the education of a young relative, you can also make contributions into a 529 account for them. These contributions are still regarded as gifts by the IRS. However, you can place as much as $75,000 (or $150,000 for married couples) into a 529 account for one beneficiary in one lump sum. That contribution is treated like five $15,000 gifts made over five years. That means that you cannot give more money to the 529 beneficiary during that time without incurring the gift tax. Still, it’s a great way to financially support your relatives while avoiding unnecessary taxes.
What About Loans?
If you thought gifting money free and clear is complicated, then wait until you hear about the rules for loans. The gist of it is that when you lend money to someone, you are required to pay taxes on interests you are supposed to charge. Yes, even if you don’t want to charge them interest at all. The IRS has a “below-market interest rule.” It basically says that you are to calculate imaginary interest payments from the borrower. If interest payments exceed the annual gift tax amount (the $15,000 amount in 2021), then you need to add that interest payment as income on your tax return to be taxed.
That’s not all. The IRS publishes an applicable federal rate (AFR) table. Any loan you make must at least charge that interest rate or more. To further complicate matters, there’s a different rate for short term, mid-term, and long-term loans. That interest rate is tied to the bond market. The good news is that the AFR is fairly low right now. Still, as of writing, the short-term rate is about 1.60% and a long-term rate of 2.07%.
You should think twice before offering an interest free loan to someone. For many cases, it’s much easier to just charge them a low amount of interest. Otherwise, just consider gifting them the entire amount.
The Bottom Line
The gifts of money should be mutually beneficial for the giver and the recipient. The giver will see their money used to help the life of loved one. The recipient will get an opportunity to improve their own financial situation. So when you decide on giving a large gift of money to a family member or friend, do your research. Take the time to determine how to make the most of your gift without having to send a chunk to the IRS. Make sure you figure all the logistics and details out before you talk to the potential recipient. It just makes everything much more complicated if you have to alter a promised gift due to tax implications.