Ken Clark, CFP, tells us about the Annual Gift Exclusion and how it affects taxable income (it doesn't) and estate taxes (it does) in Rules for the Annual Gift Exclusion for Parents and Grandparents. Most people don't know the rules about gifting, say, an amount of money to your kids or grandkids. But it is rather simple. According to Ken,
Many people seem to think that if you give a certain amount of money to someone else, it is considered taxable income and must be reported. They also think that the annual gift tax exclusion is the amount you give that person that won’t be taxed. Both of these explanations are incorrect.In fact, the gift exclusion is only applicable to the giving person's estate tax. That is to say that if you give more than the yearly exclusion allows (currently $12,000) to any one person in the form of a direct gift to that individual, your estate tax may be affected, but only if you have more than $2 million dollars in assets.
You could certainly give $12,000 to 100 people, and your estate taxes would be unaffected; but give more than that to one person, and your exemption (the $2 million) is reduced by the difference (i.e., if you give $15,000 to your grandchild, your estate tax exemption would be reduced by $3,000, or $15,000 minus $12,000).
...Grandma can pay $50,000 in tuition directly to their grandchild’s school and it is completely outside of the gift and estate tax rules. Grandma’s $12,000 annual gift exclusion has not been used by this transaction. In fact, Grandma could still give $12,000 directly to the child.These are all facts that I didn't know until I read Ken's article.
One caveat: 529 plans (college tuition savings/investment programs) are impacted by the gift tax exclusion:
If someone puts more than the annual gift limit into a Section 529 account, it may reduce his or her estate tax exemption. However, the IRS currently allows an exception in which someone can put five years worth of their annual gift exemption into a plan in one shot.Also remember that a grandfather and grandmother can each give $12,000 to a grandchild and there are no ill effects on anyone's income or estate taxes; in short, grandma and grandpa could give Junior $24,000 in 2008 without any tax consequences whatsoever.