The holiday season inspires generosity to the people and charities we care about most. With some planning, your gifts may also generate income and estate-tax savings. Here are four strategies -- and the key factors that apply to each -- to help maximize your gifting.
1. Maximize the annual exclusion for gifts
Currently, you can give up to $12,000 each year to as many individuals as you would like without incurring any tax liabilities. For married couples, it's simplest if each spouse gifts separately, but if one spouse owns most of the assets, spouses can elect to combine this annual exclusion to jointly give $24,000 to any person tax free -- a practice known as gift-splitting.
If you elect to gift split, the election will apply to all gifts given during the entire calendar year, and generally a gift tax return must be filed by April 15 of the following year. Unless an exception applies (for example, see 3 below), gifts that exceed the annual gift tax exclusion amount are automatically subtracted from the gift-tax exemption, which will cover the first $1 million of excess gifts. Once your lifetime gift-tax exclusion is used up, the portion of a gift that is subject to gift taxes may be taxed up to the maximum rate of 46 percent in 2006. (For 2007, the rate drops to 45 percent.)
Cash gifts, made directly to family members or to trusts for their benefit, are by far the most frequent gifts, says Jon J. Gallo, a lawyer with Greenberg Glusker Fields Claman & Machtinger in Los Angeles. But it is also possible to give away tangible personal property like art, jewelry or automobiles.
Any time you make a gift of an asset that is hard to value and that may be close to or more than the annual gift tax exclusion amount, Gallo recommends you get a current qualified appraisal and consider filing a gift-tax return reporting the transfer, even if you believe there is no taxable gift. Only by filing the return and fully disclosing the gift can you start the three-year statute of limitations that generally applies to gift-tax audits.
Another tax-efficient strategy to consider is making gifts of undivided fractional (partial) interests in real estate, closely-held businesses, or family limited partnerships, Gallo says. That's because the value of these gifts for gift-tax purposes may be lower than the value of the underlying assets due to lack of marketability of the interests or the recipient's lack of control over the underlying assets, he explains.
Gallo calls these transfers "two-for-one" gifts. In addition to the potential gift-tax advantages, you may get potential estate-tax savings since the gifts should reduce the value of your current estate. If the assets appreciate after you have made your gift, that subsequent increase in value is also removed from your estate. What's more, when income-producing property is gifted, your gift will, in effect, transfer a portion of the income stream from such property.
You need to be extremely careful and consult appropriate professional advisors if you are considering making these kinds of transfers, however. The IRS has challenged the valuation of these gifts and the validity of the transfers on many grounds. Among other things, it has been argued that the person making the gift retained too much control over the underlying assets or business; the business was not properly organized or run according to its own bylaws or state laws; appraisal of the interest transferred was somehow defective or inaccurate.
The timing of your gift is critical, Gallo notes. For purposes of the 2006 annual gift-tax exclusion, gifts must be completed (received and, in the case of a check, either deposited, presented for payment, or cashed) by December 31, 2006. And this is a "use-it-or-lose-it" tax break. In other words, if you do not make gifts this year, you cannot carry over your unused gift-tax exclusion and combine it with a future year's exclusion.
2. Consider funding 529 college savings plans
The annual exclusion for gifts can also be used to fund state-qualified tuition programs. For example, contributions to a 529 college savings plan, sponsored by states to help people save for higher education expenses, are considered gifts by the account owner to the designated beneficiary. You may set up a separate 529 plan account for each child or grandchild (or anyone else you want to benefit).
These plans got a substantial boost from the Pension Protection Act of 2006, which the president signed in August. The new law makes permanent the ability of 529 account owners to take federal tax-free distributions for qualified education expenses -- a benefit that was previously scheduled to expire at the end of 2010. This makes these plans much more attractive.
"529 plans also allow any earnings to grow tax-deferred while they remain in the account," says Joseph Ciccariello, Fidelity vice president of college planning. Nonqualified distributions of earnings from 529 plans are subject to income taxes and may also be subject to a 10 percent penalty tax.
The new law may also encourage people to accelerate contributions into these plans, Gallo adds. Another federal law provision, already on the books, allows you to contribute to each 529 account with a different beneficiary up to five times the annual gift-tax exclusion amount in one year. So a single person can contribute $60,000 and married couples who gift-split can contribute $120,000.
If you take advantage of this accelerated gifting provision, a gift-tax return will need to be filed. In addition, any more gifts you give to the beneficiary during the five-year period that begins in the year you made the accelerated gift may be subject to gift taxes (alternatively, you can apply what remains of your lifetime gift-tax exclusion).
Generally, gifts to 529 plans are excluded from your estate. However, with accelerated gifts, if you die within the five-year period, a pro-rata portion of your gift will be included in your estate for federal estate tax purposes.
3. Reduce taxable income with a deduction for charitable donations
If you are anticipating an income spike this year -- for instance, because you can exercise stock options, are receiving a substantial severance package or inheritance, or are selling real estate at a profit -- you may be able to offset this tax liability with an income tax deduction on your federal tax return.
If you itemize your deductions, you should be able to take a charitable deduction for up to 50 percent of your adjusted gross income (AGI) for cash donations, and up to 30 percent of your AGI for long-term capital gain property donations to a qualified charitable organization. If your donation exceeds the limit on charitable deductions, you can usually carry forward the unused portion for up to five years.
By donating securities with long-term appreciation, rather than cash, you gain a couple of key advantages. You may be eligible to take a charitable deduction for the full market value of the securities at the time they were donated. In addition, you should not have to pay any capital gains taxes on the unrealized appreciation.
If you donate securities with short-term capital gain appreciation, you generally can only deduct your basis in the securities. Such donations, however, are subject to the 50 percent AGI deduction limitation rather than the 30 percent AGI limitation for long-term capital gain property.
While many charities may only accept cash donations, donor-advised funds, a type of charitable giving program, such as the Fidelity® Charitable Gift FundSM, are increasingly receptive to accepting gifts of special assets. Special assets are nonpublicly traded assets, including collectibles, privately held stock, and certain limited liability company (LLC) and limited partnership interests. If you are considering making these kinds of donations, you should consult with a tax or financial advisor.
A donor-advised fund can be an effective solution for tax reasons if you want to make the donation this year, but can't decide between now and December 31 which cause to support. By establishing a Giving Account® with the Fidelity Charitable Gift Fund, a public charity with a donor-advised fund program, you may be eligible to take a current income tax deduction for your irrevocable contribution, but could recommend grants on your own timetable, making them either this year or at any time in the future.
The donor-advised fund also enables you to consolidate your charitable giving in a single account. If you want to donate appreciated securities, you can avoid the administrative hassles of giving appreciated stock to numerous organizations and instead donate all the stock to one donor-advised fund account.
"Donor-advised funds are part of a fundamental shift in philanthropy toward more strategic and thoughtful giving by a broad spectrum of donors -- a shift that we believe will continue to result in more dollars flowing to the nation's charities," says David Giunta, president of Fidelity Charitable Gift Fund.
4. Pay tuition and medical expenses of family members or friends
An unlimited gift-tax exclusion is allowed for tuition you pay directly to a qualifying educational organization on behalf of another person. This exception does not apply to expenses like books, dormitory fees, or room and board. Amounts paid directly to health care providers for medical care for someone else and payments for medical insurance also qualify for the unlimited gift-tax exclusion.
It does not matter what your relationship is to the beneficiary, and these exclusions are in addition to the annual gift-tax exclusion discussed above.
As always, consult a tax advisor or estate planning advisor to determine what is best for your situation.