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Simplest Estate Reduction Strategy Is Generosity

NEW YORK (TheStreet) -- Individuals looking for a simple and effective way to reduce their future taxable estate should consider the annual gift exclusion.

What is the annual gift exclusion and how does it work?
Every U.S. citizen is allowed to give anyone $13,000 (2012 level) a year without incurring either a gift tax liability or gift tax reporting. Married couples are allowed a further benefit which allows them to split their gifts. In essence, a married couple can give any individual up to $26,000 per year. Married couples who make split gifts do have a reporting requirement. They must file IRS Form 709 on which they report their split gift.

The humble annual gift exclusion can be an effective way to transfer wealth without using any of an individual's lifetime gift exclusion or estate exemption (both currently $5.12 million in 2012).

Another advantage of using the annual gift exemption is the sheer simplicity:

  • no giving up control of a large portion of your assets
  • no administrative costs i.e. trust tax returns/legal set up costs
  • only need to file gift tax return if married couple making split gift
  • control over how much to gift each year
  • control over who to gift to each year
  • no requirement to a make gift every year
  • So how effective can annual gifts be in transferring wealth?
    Let's take a hypothetical family with a married older couple and three adult children all whom are married. The couple has a $5 million investment portfolio invested in municipal bonds yielding 3% per year. The older married couple could gift $156,000 per year using gift splitting. The math is simply 6 individuals x $26,000 (split gift). The older couple in this case would need to report these gifts on Form 709 but would use zero of their lifetime gift exclusion and estate exemption.

    Over time they can continue making or not making the annual gifts as their economic circumstances dictate. If the couple continued making the $156,000 a year in gifts after 15 years they will have transferred $2.3 million. The size of their estate would be further reduced by the earnings foregone by making the annual gifts.

    If the older couple had not pursued the gifting strategy and the $5 million portfolio would have generated an incremental $600,000 over those 15 years. So in this example the total amount of wealth transferred would be $2.9 million. The couple's investment portfolio after 15 years with the gifting strategy would be $4.9 million vs. almost $7.8 million without a gifting strategy. That represents a 38% reduction!

    Why should a couple with a $7.8 million estate worry if the current federal exemption is $5.12 million a person?
    The current federal estate exemption is slated to fall back to $1 million in 2013! Another consideration is the state estate tax. Many states have a much lower estate tax exemption amount than the federal exemption amount. For example NJ's exemption is only $675,000.

    What are the potential issues with an annual gifting strategy?
    One possible drawback is the person you are making a gift to is incapable of managing their financial affairs. In this case you may want to use a trust to protect them from themselves or creditors. Also, this strategy does not make sense for anyone with a special needs child. Gifting them money outright may jeopardize their governmental benefits. In this case the correct way to give to them would be via a special needs trust. Finally, if the older couple had a shorter than expected life expectancy that would diminish the amount given. However, the couple's untimely death would be somewhat offset by less growth in their investments.

    The annual gift is a humble but effective solution to wealth transfer. For those of you with larger estates it can still be an effective tool in your estate planning toolbox.

    --By Michael Maye

    Maye is the founder and president of MJM Financial Advisors (www.mjmfinadv.com), a registered investment advisory firm in Berkeley Heights, N.J. He is a member of the National Association of Personal Financial Advisors (NAPFA) and has been a speaker covering tax topics at NAPFA's national and regional conferences. Maye has also been a frequent contributor to the Star Ledger of New Jersey's "Biz Brain" and "Get With the Plan" articles. In addition to NAPFA, he is a member of Financial Planning Association, American Institute of Certified Public Accountants, New Jersey State Society of CPAs and the Estate Planning Council of Northern New Jersey.

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