Why Know the Tax Implications of Giving Money or Inheritance?

Moving wealth, whether through lifetime gifts or bequests after death, involves various tax rules affecting both the giver and recipient. Understanding these rules helps ensure financial decisions align with intentions. This knowledge allows individuals to manage resources effectively and distribute wealth as intended, without unexpected tax burdens.

Understanding Gift Tax Implications

The federal gift tax applies to transfers of assets made during a person’s lifetime where nothing of equal value is received in return. The Internal Revenue Service (IRS) defines a gift as any transfer to an individual, directly or indirectly, where full consideration in money or money’s worth is not received. This tax is generally paid by the giver, not the recipient. However, most gifts do not result in a tax liability due to specific exclusions and exemptions.

A primary concept in gift tax is the annual gift tax exclusion. For 2025, an individual can give up to $19,000 to any number of people each year without having to report the gift to the IRS or incurring gift tax. This exclusion is per recipient, meaning a person can give $19,000 to multiple individuals in the same year without any tax consequences. For example, an individual could gift $19,000 to a child, $19,000 to a grandchild, and $19,000 to a friend in the same year, and none of these gifts would be taxable or require reporting.

Gifts exceeding the annual exclusion amount begin to count against a person’s lifetime gift tax exemption. This exemption is a cumulative amount that can be gifted over an individual’s lifetime without incurring gift tax. For 2025, the lifetime gift tax exemption is $13.99 million per individual. If a gift exceeds the annual exclusion, the excess amount reduces this lifetime exemption. For instance, if an individual gives $25,000 to one person in 2025, the $6,000 exceeding the annual exclusion ($25,000 – $19,000) would reduce their lifetime exemption by that amount.

While exceeding the annual exclusion requires filing IRS Form 709, a gift tax return, it does not automatically mean gift tax is owed. The tax is only paid once the cumulative amount of taxable gifts over a lifetime exceeds the $13.99 million lifetime exemption. Married couples have additional flexibility through “gift splitting.” This allows them to combine their individual annual exclusions, effectively doubling the amount they can give tax-free to any single recipient. For 2025, married couples can collectively gift up to $38,000 to one person without using their lifetime exemption.

To utilize gift splitting, married couples must:
Be legally married.
Both be U.S. citizens or residents.
Both consent to split the gifts by filing Form 709.

This election applies to all eligible gifts made by either spouse during that tax year. Even if only one spouse made the gift, it is treated as if each spouse made half of the gift for tax purposes.

Understanding Estate Tax Implications

The federal estate tax is a tax imposed on the transfer of a deceased person’s property to their heirs. Unlike the gift tax, which applies to transfers during life, the estate tax applies to the total value of assets owned at the time of death. The calculation begins with determining the “gross estate,” which includes nearly all property interests the decedent held at death. This encompasses a wide range of assets, such as real estate, bank accounts, investments like stocks and bonds, business interests, and even life insurance proceeds if the decedent had incidents of ownership. The fair market value of these assets at the date of death is used for valuation.

After calculating the gross estate, certain deductions are allowed to arrive at the “taxable estate.” These deductions can include mortgages and other debts, estate administration expenses, and property passing to a surviving spouse (unlimited marital deduction) or qualified charities. The federal estate tax primarily affects very large estates due to a substantial exemption amount. For 2025, the federal estate tax exemption is $13.99 million per individual. This means an estate is generally only subject to federal estate tax if its value exceeds this threshold.

The federal estate tax exemption functions similarly to the lifetime gift tax exemption because they are unified; any portion of the lifetime gift exemption used during life reduces the amount available for the estate tax exemption at death. For married couples, the exemption effectively doubles. For 2025, married couples can collectively shield up to $27.98 million from federal estate taxes. This combined exemption is aided by a provision known as “portability.”

Portability allows a surviving spouse to use any unused portion of their deceased spouse’s federal estate tax exemption. If the first spouse to die does not use their entire exemption, the remaining amount can be transferred to the surviving spouse. This can significantly increase the total amount the surviving spouse can pass on tax-free. To claim portability, the executor of the deceased spouse’s estate must generally file a federal estate tax return (Form 706) within a specific timeframe, typically nine months after death, even if no tax is owed. This election is not automatic and requires proper filing to preserve the unused exemption.

Understanding Inheritance Tax and Basis Rules for Recipients

When considering the tax implications for recipients of wealth, it is important to distinguish between federal and state-level taxes. The federal government does not impose an “inheritance tax” on beneficiaries. Instead, the federal estate tax is levied on the deceased person’s estate before assets are distributed to heirs. This means that, at the federal level, heirs generally receive their inheritance free of income tax.

However, some states do impose an inheritance tax, which is levied directly on the beneficiary receiving the inheritance. These state inheritance taxes differ from estate taxes in that the tax burden falls on the recipient, and the tax rate often depends on the beneficiary’s relationship to the deceased. For instance, close relatives like spouses, children, or parents may be exempt or face lower rates, while more distant relatives or unrelated individuals might pay higher taxes. States that levy an inheritance tax include:
Iowa
Kentucky
Maryland
Nebraska
New Jersey
Pennsylvania

Maryland is unique in that it imposes both an estate tax and an inheritance tax.

A critical concept for recipients of inherited assets is the “step-up in basis” rule. When an asset is inherited, its cost basis for tax purposes is adjusted to its fair market value on the date of the original owner’s death. This adjustment can significantly reduce or eliminate capital gains tax for beneficiaries if they later sell appreciated assets. For example, if someone inherits stock purchased years ago for $10,000 that is worth $100,000 at the time of death, their new basis becomes $100,000. If they then sell the stock for $105,000, they would only owe capital gains tax on the $5,000 increase from the date of death, not the $95,000 increase from the original purchase price.

This “step-up in basis” contrasts with the “carryover basis” rule for gifted assets. When assets are gifted during the giver’s lifetime, the recipient generally takes on the donor’s original cost basis. If the recipient later sells a gifted asset that has appreciated, they would owe capital gains tax on the full appreciation from the donor’s original purchase price. Understanding these basis rules is important for future tax planning, as it can influence decisions on whether to gift assets during life or transfer them at death, depending on the asset’s appreciation and the recipient’s circumstances.

Strategic Considerations for Givers

Understanding the tax implications of wealth transfer enables givers to make informed decisions about their financial and estate planning. This knowledge allows for proactive strategies to manage wealth distribution effectively, aiming to align transfers with personal goals and potentially mitigate future tax liabilities. For individuals with substantial wealth, comprehending gift and estate tax rules can be instrumental in reducing potential estate tax burdens.

Leveraging the annual gift tax exclusion is a straightforward and effective wealth transfer strategy. By consistently gifting up to the annual exclusion amount each year to multiple recipients, individuals can transfer significant sums over time without incurring gift tax or using their lifetime exemption. For 2025, this means an individual can give $19,000 per recipient annually, and a married couple can give $38,000 per recipient using gift splitting. This method allows for regular, tax-free wealth distribution, supporting family members or other beneficiaries over many years.

For those whose estates may approach or exceed the federal exemption amounts, understanding the unified nature of the gift and estate tax exemption is important. While lifetime gifts exceeding the annual exclusion reduce the estate tax exemption, strategic gifting can still be beneficial. Gifting assets that are expected to appreciate substantially can remove that future appreciation from the taxable estate, potentially saving on estate taxes in the long run. This requires careful consideration of current and projected asset values.

Beyond tax efficiency, knowledge of these rules empowers givers to achieve broader financial objectives. This includes providing financial support to family members for education, housing, or other needs, or engaging in charitable giving. Understanding how gifts and bequests are treated for tax purposes ensures that these acts of generosity are structured in the most advantageous way possible, maximizing the benefit to the recipient while minimizing unintended tax consequences for the giver’s overall financial picture.