Why is it Better to Pay Gift Taxes Rather Than Estate Taxes?

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You may hear an advisor refer to gift and estate taxes as being  “tax exclusive” or “tax inclusive,” respectively. This terminology is sometimes confusing, and may be better understood by saying that a gift is tax exclusive, because the taxes due are not subtracted from the gifted amount going to the heirs, but are paid separately by the donor (giver). Estate taxes, on the other hand, are paid out of the total assets received by the heirs. Perhaps an illustration will be helpful.

Assume that a donor (we’ll call him Dad) has assets totaling $5,000,000 and that he has already used his entire estate and gift tax exemption. Assume also that the gift and estate tax rate are both 40%. He makes a taxable gift of $2,000,000. Here is how the estate would look after the gift is given, and the gift tax is paid:

Available Assets                                    $5,000,000

Minus Gift Amount                              (2,000,000)

Minus Gift Taxes                                  (800,000)

Estate at Death                                     $2,200,000

Minus Estate Tax                                 (880,000)

Estate Left for Heirs                            $1,320,000

Plus Previous Gift                                $2,000,000

TOTAL BENEFIT TO HEIRS:                  $3,320,000

Note that the remaining estate for the heirs is $1.32 million, plus they received the $2 million gift, so the heirs received a total of $3,320,000 from Dad’s $5,000,000 estate.

On the other hand, this is what it would look like if instead of giving a gift, Dad simply waited to pass the money at his death:

AvailableAssets $5,000,000
TaxableEstateatDeath $5,000,000
Minus40%EstateTax (2,000,000)

In the first scenario, the heirs received $320,000 more through Dad’s lifetime gifting program than they did by waiting until Dad’s death. That extra benefit happens to be 40% of the $800,000 paid in gift taxes. So the estate tax calculation included that $800,000 (tax inclusive), while it was excluded from the gift tax calculation (tax exclusive).