Rules for the Annual Gift Exclusion for Parents and Grandparents

There are few tax rules that seem to confuse parents and grandparents as much as the “annual gift exclusion.” 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.

The annual gift exclusion has nothing to do with the portion of your tax return known as “ordinary income,” which includes wages and profits from a business. It actually has to do with gift and estate taxes, or the amount the government charges people if they give away or die with too much money.

In the United States, every person that dies with more than a certain amount is charged a “death tax” on the excess if the money goes to anyone besides their spouse. Currently, the limit is $3,500,000 per person.

To keep people from avoiding estate taxation by giving away all their money right before they die, the IRS also puts limits on the amount you can gift in any one year to any one person, as well as a cumulative limit over their lifetime for gifts that exceed the annual exemption amount.

In 2009, this annual gift exclusion is $13,000 per recipient, per year. The lifetime gift limit is $1,000,000. Anything you give in excess to $13,000 per recipient, per year is essentially subtracted from the lifetime limit of $1,000,000. This simultaneously reduces the amount the can be transferred tax-free at death.

(The actual mechanics of how these amounts avoid taxes is more complex than the scope of this article. To learn more about how these large amounts avoid taxation, take a look at IRS Publication 950 or talk to your tax professional).

For example, if I give $15,000 to my son, my lifetime gift exemption and estate tax exemption are reduced by $2,000 (the excess above $13,000). However, if I give $13,000 to 10 different people ($130,000 total) there is no reduction in either limit because I did not exceed the limit to any one person.

The only time a recipient would ever get taxed is if the donor exceeds their lifetime gift exemption while still alive and refuses to use their credit or to pay the “gift” tax. Then, in theory, the IRS could ask the recipient to pay it.

College Planning Applications:

There’s even more confusion when it comes to paying for college and the annual gift tax exclusion. First of all, anyone is allowed to pay unlimited educational or medical bills of any other person (even if they’re unrelated) without having to worry about the annual gift limit. The only requirement is that the payment be made directly to the institution.

In other words, 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 $13,000 annual gift exclusion has not been used by this transaction. In fact, Grandma could still give $13,000 directly to the child.

The place that the annual gift exclusion limit does matter is in the funding of Section 529 plans. 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.

Remember also, that this is per donor. So, grandma could put in five years' worth for a child and Grandpa could also put in five years' worth of annual gift tax exclusions. However, they could not give any additional gifts to that child within the following five years.