With 70 million baby boomers alive today, accounting for nearly $80 trillion in wealth (half of America's total wealth), being smart about transferring wealth has never been more essential. Whether you are building and protecting your wealth from scratch or had a head start from an inheritance, one of your top goals is to pass it smoothly and efficiently to your loved ones or chosen beneficiaries. 

However, transferring assets upon death can trigger a wide range of tax implications that, if not carefully planned for, can shrink the value of your estate. Last month, in an article entitled "How to Transfer Assets After Death", we explored how a beneficiary would go about the transfer process of an inherited asset after the asset owner has passed away.

This article delves into the tax implications of inheriting various types of assets and provides some possible actionable strategies to help minimize the tax burden on you and your beneficiaries.

Estate tax: what it is and how it affects your heirs

The federal estate tax is imposed when transferring the taxable estate of a deceased person. As of 2024, the federal estate and gift tax exemption is $13.61 million per individual ($27.22 million for married couples). While estates valued below this threshold are exempt from federal estate taxes, those exceeding this amount could face a tax rate of up to 40%. The exemption is set to drop back to $5 million in 2026, barring legislative action. Still, tax-free gifts made before the exemption drops will not trigger higher tax bills even if their accumulated value exceeds the new exemption threshold.

Possible strategies to minimize estate tax:

• Gifting During Lifetime. Consider making tax-free gifts up to the annual exclusion amount ($18,000 per recipient in 2024, twice that amount by a married couple) to reduce the size of your taxable estate.
• Utilizing Trusts. Establishing an irrevocable trust, such as a Grantor Retained Annuity Trust (GRAT) or a Charitable Remainder Trust (CRT), can help reduce the value of your taxable estate while providing for your beneficiaries or charities.
• Spousal Portability. If you're married, ensure your estate plan takes advantage of the estate tax exemption's portability, allowing the surviving spouse to use any remaining portion of the deceased spouse's exemption.

Income tax considerations for inherited assets

Unlike estate tax, income tax is imposed on the earnings the inherited asset generates after the decedent's death. Whether a beneficiary faces income taxes depends on the nature of the inherited asset.

• Investment Accounts. Inherited investment accounts, such as stocks, bonds and mutual funds, benefit from a 'step-up in basis.' The beneficiary's cost basis in the asset is adjusted to its fair market value (FMV) on the date of the decedent's death, often higher than the original purchase price. This detail can reduce capital gains taxes when the asset is sold.
• Retirement Accounts. Inherited traditional IRAs, 401(k)s, and other tax-deferred retirement accounts do not benefit from a step-up in basis. Beneficiaries will owe income tax on distributions taken from these accounts, and the rules vary based on the beneficiary's relationship to the decedent. For example, surviving spouses can roll over the account into their own IRA, while non-spousal beneficiaries must withdraw all assets within ten years.

Possible strategies to minimize income tax:

• Roth Conversions. If you anticipate that your beneficiaries will face high income tax rates, consider converting traditional IRAs to Roth IRAs, for example. Although this creates a taxable event for you, it allows the assets to grow tax-free and be withdrawn tax-free by your beneficiaries.
• Qualified Charitable Distributions (QCDs). For account holders over 70½, making charitable donations directly from your IRA custodian can reduce the taxable amount of yearly required minimum distributions (RMDs). Doing so can lower the income tax burden on your estate. 

Capital gains tax: inherited real estate and personal property

Inherited real estate and personal effects (such as art, jewelry, or collectibles) also receive a step-up in basis, which can significantly reduce capital gains tax liability for your beneficiaries.

For instance, if you purchased a property for $300,000 and its value at your death is $650,000, the beneficiary's basis in the property would be $650,000. If the property is later sold for $750,000, capital gains tax would only apply to the $100,000 appreciation since your death.

Possible strategies to minimize capital gains tax:

• Holding Assets Until Death. If possible, retain ownership of highly appreciated assets until death to allow beneficiaries to benefit from the step-up in basis.
• Charitable Remainder Trusts. For highly appreciated assets, consider placing them in an irrevocable charitable remainder trust. Doing so allows the asset to provide one or more living beneficiaries with an income stream, be sold without incurring immediate capital gains tax and eventually benefit a qualified charity of your choice.

State-specific considerations: estate and inheritance taxes

Besides federal taxes, state-specific taxes must also be considered. Some states impose their own estate taxes with exemption thresholds that are lower than the federal level. Other states impose an inheritance tax to be paid by the beneficiaries instead of by the estate.

Possible strategies to minimize state taxes:

• Relocation. While relocation may seem drastic, if you live in a state with a high estate or inheritance tax, consider moving to one with more favorable tax laws. However, carefully research the residency requirements and how relocation impacts your overall financial plan.
• State-Specific Trusts. Establishing state-specific trusts, such as an irrevocable Qualified Personal Residence Trust (QPRT), may help reduce the value of your taxable estate in high-tax states.

Special considerations for business interests

If you own a business, your estate's overall tax burden can be significantly impacted by its value, putting business continuity and legacy at risk. Without proper planning, beneficiaries in such circumstances often face challenges – including liquidity issues – that could force the sale of the business to cover the tax bill.

Possible strategies to minimize taxes on business interests:

• Family Limited Partnerships (FLPs). Establishing an FLP could help you slowly transfer business ownership to family members over time, using valuation discounts and the yearly gift tax exclusion to lessen the tax liability.
• Buy-Sell Agreements. You might be able to provide the necessary liquidity for your heirs to pay the tax bill without selling the business through a buy-sell agreement funded by life insurance. The earlier this is set up, the less the insurance component might cost.
• Section 6166 Election. Section 6166 of the Internal Revenue Code permits estate tax payments to be deferred over 15 years in cases where the business makes up a significant portion of the estate's total value, thus easing the immediate tax burden on your heirs.

Charitable giving as a tax-reduction strategy

You might reduce the taxable value of your estate by including charitable giving in your estate plan while still providing meaningful support to causes you care about. Charitable giving can be structured in several ways to maximize tax benefits. Here are a few:

• Charitable Bequests. You can reduce the taxable value of your estate dollar for dollar by making direct gifts to charities in your will.
• Donor-Advised Funds. Donor-advised funds let you make charitable contributions and receive immediate tax deductions. You can then recommend grants to charities calmly over time. 
  
• Charitable Lead Trusts (CLTs) and Charitable Remainder Trusts (CRTs). These trusts are designed to provide income to qualified charities for specified periods while potentially lowering estate and income taxes. They differ primarily in terms of which party receives the income stream during the life of the trust and which receives the remaining assets at the end of the period.

Planning ahead to protect your legacy

Understanding the tax implications of your estate is critical to ensuring your wealth is transferred according to your wishes with minimal burden on your beneficiaries. While the mentioned strategies are not exhaustive, by proactively implementing some of these (or others), you can safeguard your legacy and ensure more wealth stays with your heirs, not the IRS.

These issues are complex and often interrelated, making it essential to work with an experienced financial professional who can help you navigate the intricacies of tax planning, estate law and wealth transfer strategies. WH Cornerstone has accrued the experience needed to help you protect the wealth that reflects a lifetime of effort.

If, on the other hand, you are the beneficiary of an estate – whether you are a family member, a friend or a charity – we can help you unravel what you have received. We are prepared to recommend actions you can take to maximize the value of your inheritance while minimizing the portion that taxation takes.

For help with this process, schedule a call with us. We’re here to help.