Estate Planning Blog Articles

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Can Estate Planning Reduce Taxes?

The estate tax exemption won’t always be so high. The runup in housing prices may mean capital gains taxes become a serious issue for many people. There are solutions to be found in estate planning, including one known as an “Upstream Power of Appointment” Trust, as explained in the article “How to Use Your Estate Plan to Save on Taxes While You’re Still Alive!” from Kiplinger.

The strategy isn’t for everyone. It requires a completely trustworthy, elderly and less wealthy relative, such as a parent, aunt, or uncle, to serve as an additional trust beneficiary. First, here is some background information:

Basis: This is the amount by which a price is reduced to determine the taxable gain. This is often the historical cost of an asset, which may be adjusted for depreciation or other items. Estate planning attorneys are familiar with these terms.

Step-up (in-basis): If you bought a house for $100,000 and sold it for $400,000, your taxable gain would be $300,000. However, if the house had belonged to your father and was being sold to distribute assets between you and your siblings, the basis (cost) would be increased to the fair market value at the date of your father’s passing. This increase is known as the “step-up in basis” and here’s the benefit: there would be no capital gain on the sale and no taxes owed.

Lifetime estate tax exemption: This is currently at $12.06 million per person or $24.12 for married couples. This is the amount of assets which can be passed to children or others free of any federal estate tax. However, the number will take a deep dive on January 1, 2026, when it reverts back to just under $6 million, adjusted for inflation. Plan for the change now, because 2026 will be here before you know it!

Upstream planning involves transferring certain appreciated assets to older or other family members with shorter life expectancies. Since the person is expected to die sooner, the basis step-up is triggered sooner. When the named person dies, you obtain a basis step-up on the asset, saving income taxes on depreciation and saving capital gains on a future sale of the property.

Most Americans aren’t worried about paying estate taxes now, but no one wants to pay too much in income taxes or capital gains taxes.

To make this happen, your estate planning attorney will need to give an elderly person (let’s say Aunt Rose) the general power of appointment over the asset. Section 2041 of the Internal Revenue Code says you may give your Aunt Rose a power to appoint the asset to her estate, creditors, or the creditors of her estate. Providing the power will include the value of the property in her estate, not yours, ensuring the basis step-up and income tax savings.

Don’t do this lightly, as a general power of appointment also gives Aunt Rose ownership and the right to give the property to herself or anyone she wishes. Can you protect yourself, if Aunt Rose goes rogue?

While the IRC rule doesn’t require Aunt Rose to get your permission to control or change distribution of the property, a trust can be crafted with a provision to effectuate the desired result. The IRC doesn’t require Aunt Rose to know about this provision. This is why the best person for this role is someone who you know and trust without question and who understands your wishes and the desired outcome.

Proper planning with an experienced estate planning attorney is a must for this kind of transaction. All the provisions need to be right: the beneficiary need not survive for any stated period of time, you should not lose access to the assets receiving the basis increase, you want a formula clause to prevent a basis step down if the property or asset values fall and you want to be sure that assets are not exposed to creditor claims or any other liabilities of the person holding this broad power.

Reference: Kiplinger (July 3, 2022) “How to Use Your Estate Plan to Save on Taxes While You’re Still Alive!”

What Is the Best Way to Leave Money to Children?

Parents and grandparents want what’s best for children and grandchildren. We love generously sharing with them during our lifetimes—family vacations, values and history. If we can, we also want to pass on a financial legacy with little or no complications, explains a recent article titled “4 Tax-Smart Ways to Share the Wealth with Kids” from Kiplinger.

There are many ways to transfer wealth from one person to another. However, there are only a handful of tools to effectively transfer financial gifts for future generations during our lifetimes. UTMA/UGMA accounts, 529 accounts, IRAs, and Irrevocable Gift Trusts are the most widely used.

Which option will be best for you and your family? It depends on how much control you want to have, the goal of your gift and its size.

UTMA/UGMA Accounts, the short version for Uniform Transfers to Minor or Uniform Gift to Minor accounts, allows gifts to be set aside for minors who would otherwise not be allowed to own significant property. These custodial accounts let you designate someone—it could be you—to manage gifted funds, until the child becomes of legal age, depending on where you live, 18 or 21.

It takes very little to set up the account. You can do it with your local bank branch. However, the funds are taxable to the child and if an investment triggers a “kiddie tax,” putting the child into a high tax bracket and in line with income tax brackets for non-grantor trusts, it could become expensive. Your estate planning attorney will help you determine if this makes sense.

What may concern you more: when the minor turns 18 or 21, they own the account and can do whatever they want with the funds.

529 College Savings Accounts are increasingly popular for passing on wealth to the next generation. The main goal of a 529 is for educational purposes. However, there are many qualified expenses that it may be used for. Any income from transfers into the account is free of federal income tax, as long as distributions are used for qualified expenses. Any gains may be nontaxable under local and state laws, depending on which account you open and where you live. Contributions to 529 accounts qualify for the annual gift tax exclusion but can also be used for other gift and estate tax planning methods, including letting you make front-loaded gifts for up to five years without tapping your lifetime estate tax exemption.

You may also change the beneficiary of the account at any time, so if one child doesn’t use all their funds, they can be used by another child.

From the IRS’ perspective, a child’s IRA is the same as an adult IRA. The traditional IRA allows an immediate deduction for income taxes when contributions are made. Neither income nor principal are taxed until funds are withdrawn. By contrast, a Roth IRA has no up-front tax deduction. However, any earned income is tax free, as are withdrawals. There are other considerations and limits.  However, generally speaking the Roth IRA is the preferred approach for children and adults when the income earner expects to be in a higher tax bracket when they retire. It’s safe to say that most younger children with earned income will earn more income in their adult years.

The most versatile way to make gifts to minors is through a trust. There’s no one-size-fits-all trust, and tax rules can be complex. Therefore, trusts should only be created with the help of an experienced estate planning attorney. A trust is a private agreement naming a trustee who will manage the assets in the trust for a beneficiary. The terms can be whatever the grantor (the person creating the trust) wants. Trusts can be designed to be fully asset-protected for a beneficiary’s lifetime, as long as they align with state law. The trust should have a provision for what will occur if the beneficiary or the primary trustee dies before the end of the trust.

Reference: Kiplinger (May 15, 2022) “4 Tax-Smart Ways to Share the Wealth with Kids”

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