One of the most effec­tive estate plan­ning tools for per­sons look­ing to reduce their estates for gift and estate tax pur­poses is to make “annual exclu­sion” gifts each year to their loved ones in lower gen­er­a­tions. Typically, such gifts are made in January. In this way, should the donor pass away later in the year, the oppor­tu­nity to make annual exclu­sion gifts will not have been lost.

The annual exclu­sion is the largest amount that an indi­vid­ual can give in any par­tic­u­lar year to each of their loved ones with­out incur­ring fed­eral gift taxes or reduc­ing their life­time exemp­tion from gift and estate taxes. (The life­time exemp­tion, known tech­ni­cally as the “applic­a­ble exclu­sion amount,” is the aggre­gate amount that an indi­vid­ual may give dur­ing life­time and at death with­out incur­ring fed­eral gift or estate taxes.) The annual exclu­sion is indexed for infla­tion so it increases in amount in some years. This year, how­ever, the IRS has announced that the annual exclu­sion will remain at $13,000, the same fig­ure it has been since 2009.

To demon­strate the power of annual exclu­sion gifts, sup­pose that a mar­ried cou­ple in their six­ties has four adult chil­dren, all of them mar­ried, and ten grand­chil­dren in all. Each grand­par­ent can make an annual exclu­sion gift to each of their four chil­dren, their children’s four spouses (if desired), and their ten grand­chil­dren. That amounts to eigh­teen annual exclu­sion gifts per grand­par­ent, or thirty-six gifts in total. Multiplied by the annual exclu­sion amount of $13,000, those thirty-six gifts will reduce the grand­par­ents’ com­bined estates by $468,000 in a sin­gle day with­out any adverse gift or estate tax consequences.

If one spouse is wealthy and the other is not, the wealthy spouse can make all of the gifts and, with their spouse’s con­sent, treat the gifts as made one-half by each of them. (This is referred to as “split­ting gifts.”) As a result, the non-wealthy spouse can in effect make annual exclu­sion gifts that they oth­er­wise could not afford.

Gifts between spouses are usu­ally dis­re­garded for gift and estate tax pur­poses, a con­se­quence of the gift and estate tax unlim­ited mar­i­tal deduc­tion. An excep­tion arises, how­ever, if one of the spouses is not an American cit­i­zen. Gifts by an American cit­i­zen to their spouse do not qual­ify for the mar­i­tal deduc­tion. Instead, to par­tially com­pen­sate for the loss of the mar­i­tal deduc­tion, gifts to a non-citizen spouse are sub­ject to an aug­mented annual exclu­sion amount. For 2012, that fig­ure is $139,000, up from $136,000 in 2011. Gifts not exceed­ing $139,000 will there­fore be dis­re­garded for gift and estate tax purposes.

Of course, as the law stands today, rel­a­tively few peo­ple need con­cern them­selves with fed­eral gift and estate taxes because the life­time exemp­tion from those taxes (for American cit­i­zens and non-citizens who are domi­ciled in the US) stands at $5,120,000 per per­son. However, this is a tem­po­rary arrange­ment between Democrats and Republicans in the nation’s cap­i­tal, a polit­i­cal stale­mate. New laws are sup­posed to be in place effec­tive January 1, 2013. What those laws will pro­vide no one can say.

Be aware that most states also impose estate or inher­i­tance taxes, and a few even impose gift taxes. New York has no gift tax, and the exemp­tion from estate taxes is fixed at $1,000,000. The max­i­mum estate tax rate in New York is 16%. With very high fed­eral exemp­tions in place, the focus in estate plan­ning is shift­ing from fed­eral to state estate and inher­i­tance tax savings.