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How to Trim Taxes While Playing Santa

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Oct 30th 2014
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For many individuals, a key part of their investment and estate planning is to write yearend checks for gifts to family members. The following reminders will help put your tax planning in perspective for 2014 and beyond, and keep in mind what does, or does not, save on taxes.

Unlike with charitable contributions, you get no income-tax deductions for gifts to individuals. Nevertheless, these gifts can be advantageous because they shift investment income from yourself to family members in lower brackets, as well as reduce the value of your assets subject to estate taxes at your death.

As part of your planning, you need to consider gift taxes when you make sizable lifetime transfers of money or other assets. Fortunately, gift taxes present no problems for most persons. Usually, it's possible to get around these taxes, courtesy of annual exclusions of $14,000.

The exclusions become $28,000 when you're married and your spouse joins in—a maneuver known as "gift splitting." It makes no difference that your spouse lacks separate resources to take advantage of the exclusion and the entire gift comes from your assets. Those $14,000 and $28,000 figures are for gifts in any single year to any one person.

These annual exclusions permit you to pass along as much as $14,000 (or $28,000) a year to each of as many of your children, grandchildren, other relatives or friends as you like and can afford. You can do so without worrying about payment of gift taxes or using up part of your exemption from gift taxes—$5,340,000 for 2014. The annual exclusion amounts will be adjusted for inflation in later years.

Unlimited exclusions for some kinds of gifts. It's possible to effectively give much more than $14,000 in one year to one person without any liability for gift taxes. You qualify for an unlimited exclusion for qualified transfers when you pay medical bills or tuition, full-time or part-time, directly for anyone. The object of your generosity needn't be your dependent or even related to you.

Suppose you've the financial wherewithal to help an elderly parent with medical charges for hospitals, drugs, or doctors that aren't covered by Medicare—for instance, hearing aids, dental work, or private duty nurses. Or perhaps you want to assist grandchildren with tuition, from elementary school through graduate school. Lending a hand earns you special consideration. Those kinds of gifts don't count against the $14,000 annual exclusions, provided the payments go directly to medical-care providers or educational institutions, rather than to the individuals whose expenses you're paying.

Inevitably, some restrictions apply. Your tax strategy comes undone if you turn the money over to someone you seek to assist. This is so even if that person uses the funds for medical charges or tuition. Tuition payments must be made to a qualifying educational organization, meaning one with a regular faculty, an established curriculum, and an organized student body. There're no unlimited exclusions for books, supplies, dormitory fees, board, or other school expenses. However, you can give a student an additional $14,000 ($28,000 jointly) free of any gift taxes for 2014, courtesy of the annual exclusions.

An IRS ruling that generated a lot of buzz shows how adroit use of unlimited exclusions by affluent individuals allows them to remove big chunks of assets from their estates. The ruling approved unlimited exclusions for prepayments of future tuition charges.

It all began when an ailing grandmother became concerned that she might not survive all of her grandchildren's years of schooling. She sought a way to make a bequest before she died and also save on estate taxes. So the tax-savvy grandmother decided to prepay several hundred thousand dollars to a private school to cover many years of tuition for two of her grandchildren.

Shortly thereafter, she died, and her estate tax return was audited. An IRS sleuth readily conceded that the grandmother's taxable estate should be reduced by payments for tuition already provided. But should it also be reduced by tuition prepayments that were unspent at the time of her death? Yes, ruled the IRS, inasmuch as the prepayments were nonrefundable. (IRS Technical Advice Memorandum 199941013.)

As for qualifying medical expenses, they're the same ones that qualify as income tax deductions. But if you pay someone's medical expenses, be sure that person isn't reimbursed by insurance, for instance. In that case, the payment is ineligible for the unlimited exclusion, and you're considered to have made a gift when that person is reimbursed. Also keep in mind the income tax deduction that might become available to your prospective gift recipient if that person makes the medical payment himself.

No need to concern yourself with exclusions, whether annual or unlimited, when you make legally required payments. You make no gifts when, for instance, you pay for a dependent child's medical care or tuition.

About the author:

Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from "Julian Block's Year Round Tax Strategies", available at julianblocktaxexpert.com.

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