Those hoping to make large gifts from their estates have a unique chance to do so tax-free during 2012. Through the remainder of this year, individuals can now gift as much as $5.12 million or $10.24 million per couple without paying any gift taxes. Under previous laws, the maximum lifetime gift tax exclusion capped out at $1 million for individuals and $2 million for couples. Gifting while these generous limits are in place may significantly lower an individual’s future estate tax liability.

But before deciding whether to take advantage of this limited window of opportunity, one must consider how much can be gifted without compromising important lifestyle or financial goals. The best method of making distributions also deserves some thought; ideally it should be done in a way that will allow the assets to continue to grow for beneficiaries of the gift.

Reasons to consider gifting

The 2010 Tax Relief Act increased the gift and estate tax exclusion limits through the end of 2012. At the same time, it lowered the maximum tax rate above these amounts to 35% from a previous level of 45%.

Assuming these provisions expire as planned at the end of this year, the lifetime gift tax exclusion is set to drop back down to $1 million for individuals—$2 million for couples—and the tax rate on estates and gifts beyond these limits will jump to 55%.

The lifetime gifting allowance is in addition to the annual gift tax exclusion that allows individuals to make an unrestricted number of nontaxable gifts of as much as $13,000 per recipient per year. This annual gift exclusion will remain in place after 2012. However, for those looking to make large-scale gifts, now is the time to consider doing so.

It is important to note that the gift cannot be adjusted or returned once it has been made. To determine an appropriate amount, those interested in making a gift should first complete a careful evaluation of how much money is needed to support their lifestyle. Making a gift without doing so could jeopardize current or future financial goals and objectives.

Determining your number

Our Wealth Advisory Group regularly conducts assessments for clients to evaluate their potential gifting capacity. Though this is often a comprehensive process involving many variables, a good foundation for calculating the number begins with what we call “the 3% rule.”

Consider this example: Let’s say a married couple holds a $20 million taxable portfolio with no tax-deferred assets. They are both 65 years old, and living expenditures total $450,000 annually. Based on average joint life expectancy tables from the Internal Revenue Service, their assets would need to last for at least 25 more years. (Time horizons vary widely depending on personal factors such as health and family history, but this gives us a good starting point.)  

We typically recommend that clients keep one to three years of living expenses in their Base portfolios (see our Wealth Strategy Pyramid, Figure 1) because we feel this amount can provide adequate liquidity to meet short-term obligations while offering emotional comfort and financial stability. However, Base portfolio recommendations vary depending on each client’s individual circumstance. For the purposes of this example, we used approximately two years of living expenses, or roughly $1 million, for the Base portfolio. That leaves a Core portfolio of $19 million, from which the couple would seek to generate the $450,000 needed to meet their annual living expenses, adjusted upward each year for inflation.

To calculate gifting capacity, the couple needs to determine how much should be left in the Core portfolio to support them for at least another 25 years. The residual amount represents Surplus assets that are available for gifting.

Based on our analysis and capital market assumptions, when spending levels represent 3% of the Core portfolio, it is likely that the assets will last at least 30 years. This assumes a 60% stock/40% municipal bond asset allocation. As seen in Figure 2, once distribution rates reach levels of 4% and higher, the probability that portfolio assets will last at least 25 years begins to fade rapidly. A 3% distribution may therefore put the couple in a more comfortable position, given ongoing equity volatility and today’s uncertain macroeconomic outlook.

Using the 3% guideline, we can determine how much should be kept in the couple’s Core portfolio to cover their expected lifetime living expenses. As shown in Figure 3 below, annual spending of $450,000 would require $15 million, which could be retained in the Core portfolio to enhance the probability of meeting their long-term spending needs. Subtracting $15 million from the $19 million currently in the Core leaves a maximum of $4 million for the Surplus that can be gifted with a low risk of jeopardizing the couple’s financial well-being, which is below the current maximum tax-free gifting allowance.

Estate tax advantages

Under current laws, lifetime gifts are added back to the value of the estate at death, but the growth on the gift avoids estate taxes. In terms of potential tax savings, Figure 4 shows that by taking advantage of the higher limits in 2012 to give away $4 million, one can significantly lower future obligations to Uncle Sam, regardless of whether exclusions and estate tax rates remain where they are or revert to previous levels. If estate tax rates stay at 35%, the estimated tax savings on a $4 million gift would be $2.6 million after 25 years and $3.6 million after 30 years. However, if estate tax rates increase to 45% (2009 levels) or 55% (2001 levels), the estimated tax savings would be even greater.

Gifting options to consider

Although the simplest gifting method among individuals is writing a check, not everyone is comfortable with a direct transfer of cash because there is no assurance that it will be saved or spent wisely. Several other options exist, such as gifting securities or setting up an investment account in the beneficiary’s name so that he or she can be involved in the investment process. Of course, the beneficiary will still have full control of the funds, but investment accounts may encourage the recipient to think of the gift as a way of building long-term wealth, as opposed to considering it “found money” that may be used for less desirable purposes. In fact, a $4 million investment today could grow to $14.2 million in a diversified portfolio over 30 years (based on the same assumptions used in Figure 4).

A trust is a good option for a younger beneficiary because assets will be protected by a trustee until the recipient meets the minimum age or other requirements dictated by the trust. Once specific conditions are met, the beneficiary gains complete control of the trust. For the charitably inclined, one type of trust that may be particularly attractive right now because of the low interest rate environment is a charitable lead trust. In this option, the grantor contributes assets to the trust. A specified charity (or charities) receives payments for a designated time, after which all remaining assets go to the beneficiary of the trust. The grantor receives a charitable gift tax deduction for the present value of the payments to charity.

Exploring your options

Compelling as the potential tax savings may be, the decision to gift a portion of one’s assets is irrevocable and requires a careful evaluation of each individual’s  unique financial situation. Our Wealth Advisory Group can work with clients and their Investment Counselors to analyze personal circumstances and help find an appropriate gifting level. n

Capital Group Private Client Services (CGPCS) does not provide tax or legal advice to its clients. Individuals should consult with their own tax and legal advisors regarding any potential strategy presented in these materials. This publication does not address the possibility that a lifetime gift may be subject to estate taxes in the future if the exclusion amount at death is less than the exclusion amount at the time the gift was made (i.e., clawback). Please discuss the potential implications of a clawback with your tax advisor. Figure 2 is based on the results of a Monte Carlo simulation using CGPCS capital market assumptions (e.g. return, volatility and correlation) at the time of this writing. For details on the capital market assumptions used in this example, please contact your Investment Counselor. Figures assume portfolios are subject to the highest marginal federal income tax rates of 35% in 2012 and 39.6% beginning in 2013. Excludes state taxes and 3.8% Medicare surtax. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with your Investment Counselor. © 2012 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.