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Gift tax vs. inheritance tax: How they impact beneficiaries

Parents with son discussing finances with advisor
10'000 Hours/Getty Images

You worked hard and saved for decades. Now it's time for the most rewarding part— sharing your money with the people you love. Transferring wealth to the next generation is a powerful way to continue your legacy and help your loved ones build a stable foundation for their future.

You can pass on your wealth through gifting, giving away assets during your lifetime. Another option is leaving an inheritance for heirs when you die. Both methods come with tax implications.

Understanding gift tax vs. inheritance tax and how these taxes may impact your beneficiaries can help you decide how to give or leave money and property to your loved ones. Here's a closer look at gift tax vs. inheritance tax, how they differ, how they relate and factors to consider when deciding which transfer method to use.

What is inheritance tax?

An inheritance tax is a state-level tax imposed on the transfer of property from one person to another upon death. The purpose of inheritance tax is to generate revenue for the state where the decedent resided or owned property. Unlike estate taxes, which are levied on a deceased person's estate, inheritance taxes are levied on recipients.

There is no federal inheritance tax. Currently, six states have an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. The amount of the tax depends on the size of the estate and the heir's relation to the deceased person. In most states, there are exemptions for close family members, such as spouses and children. There are also small estate thresholds, meaning the recipient doesn't owe an inheritance tax if the estate's value is below a certain amount.

If you live or own property in a state with an inheritance tax and want to avoid having taxes chip away at the value of your loved ones' inheritance, you can consider gifting assets during your lifetime instead—just be aware of potential gift tax consequences.

What is gift tax?

A gift tax is a tax imposed on the transfer of property from one person to another. The purpose of the gift tax is to prevent people from avoiding paying estate and inheritance taxes by giving assets away during their lifetime.

How much money can be gifted tax-free? You can leverage two exclusions to avoid paying the gift tax: the annual exclusion and the lifetime exclusion.

Annual exclusion

The annual exclusion allows you to give up to a certain amount per year to any number of recipients without triggering a gift tax return filing requirement.

The gift tax exclusion per recipient is $17,000 for 2023 and $18,000 for 2024. In other words, if you give each of your three children $18,000 in 2024, you could give away $54,000 without filing a gift tax return.

For married couples, each spouse is entitled to their own annual exclusion amount. This means a married couple could give up to $108,000 ($18,000 x 6) to their three children in 2024 without filing a gift tax return.

Keep in mind that filing a gift tax return doesn't necessarily mean you need to pay taxes on the gift—unless your total reported gifts exceed the lifetime exclusion.

Lifetime exclusion

The lifetime exclusion allows you to give away up to a certain amount during your lifetime without triggering gift or estate taxes.

The lifetime exemption is $12,92 million in 2023 and $13.61 million in 2024.

The lifetime exclusion applies to both gift and estate taxes combined, so any portion of the exemption you use for gifting reduces the amount you can use for the estate tax.

How the gift & estate tax exemption works

Here's an example of how annual and lifetime exclusions work together: Say you're unmarried and give $100,000 to your adult child in 2024. Because that gift is more than the annual exclusion, you must file a gift tax return using Form 709. Your child doesn't have to pay taxes on the gift, but your lifetime exclusion is reduced by $82,000—the amount by which your gift exceeds the annual exclusion.

Note that the current lifetime exemption, while generous, is only temporary. Unless Congress makes the existing exemption limit permanent, it may revert to $5.49 million (adjusted for inflation) after 2025. That impermanence makes gifting assets to your loved ones now more appealing. Doing so effectively "locks in" your exemption, since there's no telling what the lifetime exemption amount may be in the future.

Gift tax considerations

Gifting within the annual exclusion amount can be a way to pass wealth onto the next generation without filing a gift tax return or cutting into your lifetime exclusion. You also get to enjoy seeing the impact of your gifts on the people you care about. But it's not without its downsides—especially if you move to a long-term care facility or nursing home.

Medicare and Medicare supplemental insurance don't cover most long-term care, so your sources for paying for long-term care are limited to:

  • Your own money. Make sure that you have enough saved up before giving away your assets.
  • Long-term care insurance. This can help pay for the cost of long-term care services.
  • Medicaid. Medicaid is a government program that helps people pay for medical expenses, including long-term care. To be eligible for Medicaid, you must meet certain requirements, such as having a low income and few assets.

While there are strategies for meeting Medicaid's income and asset requirements, including using trusts, gifting assets can create a penalty for you (or your spouse) because of Medicaid's five-year look-back period.

The five-year look-back period means that if you or your spouse move to a long-term care facility or nursing home and apply for Medicaid, the state looks back at the past 60 months to make sure you didn't transfer any assets for less than their fair market value. Those transfers can include gifts and items sold for less than they're worth. Even payments to a caregiver can violate the look-back period if there isn't a written agreement in place.

There are some exceptions to this rule, including some transfers to spouses, children with disabilities, siblings, adult children caregivers and debt payments. However, transferring assets is complicated, so discuss your plans with your financial advisor first.

Partial payment gifts

Another popular approaching to passing down assets is a partial payment gift, where the recipient pays for a portion of their gift but not its full value.

For example, say your home is worth $1 million, but you sell it to your adult child for $750,000. The $250,000 difference between the home's value and the purchase price is considered a gift. As a result, you need to file a gift tax return, and your lifetime exemption is reduced.

Get professional guidance

When it comes down to gift tax vs. inheritance tax, it's crucial to understand how both taxes work and how they might affect your beneficiaries. With proper planning, you can minimize or even avoid these taxes altogether. Connect with a local financial advisor for a personalized look at your unique situation and guidance on how your assets can make the biggest impact during and after your lifetime.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.

Hypothetical examples are for illustrative purposes. May not be representative of actual results.