Estate Tax Exemption
An estate tax is applied when the value of the estate exceeds an exclusion limit set by law. This tax is applied based on fair market value, not on what the deceased originally paid for assets. The federal government and some states have estate taxes.A rollback of the estate tax exemption—to the 2009 level of $3.5 million—was proposed as part of the Build Back Better Act. However, this was not included when the bill passed in November 2021. Speculation about the proposed rollback led to a frenzy of gift-giving in late 2021.
The Gift Tax Exemption
According to the Internal Revenue Service (IRS), a gift is defined as a transfer to an individual where “full consideration (measured in money or money’s worth) is not received in return.” If you are in a position where you will owe estate tax, gifting to your heirs is a great way to reduce taxes.Who Pays the Gift Tax?
According to the IRS, the person who gives the gift is responsible for filing a gift tax return and paying the gift tax.Educational and Medical Gifts
Gifting can also be done in other ways. For example, if you directly pay your children or grandchildren’s educational expenses, it’s treated as an exemption and is not taxable. The gift must be made directly to the educational institution for tuition purposes to qualify.Gifts can also be made to pay medical bills. To be exempt from taxes, the gift must be made directly to the hospital, doctor, or other healthcare providers.
Gifting Minors and Young Adults
Although many individuals want to gift their young children or grandchildren, there are some concerns with handing over large amounts of assets to a minor.If you are concerned about assets being spent instead of used on future education, a 529 College Savings Plan might be the route to take. The monies must be used for educational purposes—there is a 10 percent penalty on the earnings if taken out for other reasons. The law allows you to front-load five years of gifting into a 529 College Savings Plan.
Money contributed to a UTMA is exempt from taxes up to the gift tax exemption amount. From an income tax perspective, any income earned on the contributed funds is taxed using the “kiddie tax” rate—which offers some tax protection as well.
‘Stepped-Up’ Strategies to Reduce Capital Gains for Heirs
The “stepped-up basis“ is a provision that reduces capital gains tax on inherited property or investments.When these assets are inherited, the IRS “steps up” their cost basis. That is, their market value is reset to the date of the original owner’s death. The heir doesn’t pay capital gains tax on any increase that occurred from the time the deceased purchased the investment or property, to the time that individual died.
For example, let’s say grandmother purchased a stock for $10 a share. When she died, it was worth $15 a share. You inherited the $15 a share stock, but you are not required to pay capital gains on the five dollars the stock earned while grandma was still alive. Why? Because your stepped-up tax basis is now $15 a share. If the stock price goes up further, you’d only need to pay the capital gain on the difference between the new price and $15, instead of on the $10 it cost when your grandmother purchased it.
If your grandmother had sold that stock while still alive, she would have had to pay the capital gains tax on the full difference. By leaving the stock to you instead of selling it and leaving you the proceeds, she was able to save on capital gains taxes and thus potentially leave you more money.
