Tracking, and Working Around, Annual Gift Limits

The federal estate tax guides not only your financial plans for how and to whom you will pass your assets, but also affects the gifts you give to friends and family while you are still around to receive their heartfelt thanks.

The estate and gift taxes are unified; that is, any gifts you give during your life to anyone other than your spouse affect the amount of your estate that eventually is exempted from the estate tax.

For 2013, estates of up to $5.25 million escape the federal estate tax. The amount is adjusted annually each tax year. Estates valued in excess of the exemption amount are taxed at a maximum 40 percent rate.

Similarly, the gift amount you can give each year is limited and also adjusted for inflation. The annual gift cap prevents unlimited gifts which would circumvent estate tax laws.

Sharing wealth now instead of later

In 2013, you may give up to $14,000 (up from $13,000 in 2012) to any person and you may give as many of these generous gifts as you wish.

In addition, each husband and wife can give $14,000, meaning that as a couple you can gift $28,000 to a sibling, child, grandchild or friend.

For example, this year a married couple with an adult child who is married and has two children could make a joint cash gift of $28,000 to their child, the child's spouse and each grandchild. Those four gifts come to $112,000 that is removed from your taxable estate.

This does not mean, however, that the $112,000 escapes tax accounting.

The gift amounts are part of the unified credit, the previously mentioned integration of the federal gift tax and estate tax into a single tax system. The gifts reduce the amount of your original $5.25 million that is exempt from the estate tax.

And while gifts are never taxable to recipients, the giver must pay attention to the annual gift limit. If a gift exceeds it, you must file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, with the Internal Revenue Service.

Gift limit exceptions, potential trust pitfalls

However, the tax code offers ways to work around the annual gift limit.

When you pay directly for a child's education, health insurance or medical expenses regardless of the amount, such a payment is not considered a gift for annual gifting purposes.

Because these types of payments made directly to insurance companies do not count, can create confusion with regard to premiums paid for insurance in an Irrevocable Life Insurance Trust, or ILIT.

An ILIT is an entity to which this gifting limit DOES apply. Premiums paid on policies used in these trusts ARE a gift to that entity and are subject to the annual exclusion.

If you do not want to file a gift tax return and use up some of your lifetime exemption, you must take care to track these premiums and other annual gifts so the limits are not exceeded.

Alternative gifting techniques

Creativity can be employed if premiums exceed the annual gifting limits. As mentioned earlier, each person is allowed this annual exemption, doubling a couple's gift giving possibilities.

Another interesting technique would be to make the gift for the annual amount and then a loan to the ILIT for the amount that exceeds the annual exclusion.

In this case, the money should truly be a loan with a signed promissory note by the trustees and appropriate interest charged. In future years, the unused part of the annual exclusion can be used to reduce the balance of the loan and pay the interest.

Also meticulously record and document the interest and loan forgiveness in the year they occur to stay under the desired gifting levels.