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The Importance of Income Tax in Estate Planning Strategy

Income tax rates play an increasingly important role in estate planning strategy as the federal estate tax exemption rises. In the late 1990s, the estate tax exemption applied to many more people than it does today. Today, it applies to only 0.2 percent of estates.

Over that same period, income tax rates have increased and shifted estate planning focus to mitigating income tax liability. 

What’s income tax basis?

Income tax basis is the amount that can be recovered tax-free when an asset is sold. The initial income tax basis is usually the asset’s cost. Tracking income tax basis is important because it’s used to calculate capital gains liability when the asset is sold. If the asset is sold for a profit, taxpayers must report a capital gain and pay taxes on the appreciation based on their income bracket (anywhere from 0 to 20 percent). This applies to estate planning in two ways: lifetime transfers and transfers after death. Let’s look at an example.

If you purchase stock worth $5,000 and then transfer that stock to a child when the stock is worth $10,000, the child’s tax basis for the stock is $5,000. If the child sells the stock immediately, he or she would owe tax on $5,000 of capital gain. If the child holds the stock, he or she will owe capital gains on appreciation of the stock’s value (including any appreciation that accrued while you owned the stock). So, if the child holds the stock and sells it when it’s worth $15,000, he or she will owe capital gains on $10,000.

Let’s assume that, instead of making a lifetime transfer, the child inherits the stock from you at the time of your death when it is worth $10,000. In this situation, any appreciation that accrued prior to your death is effectively eliminated and will never be taxed. If the child sells the stock immediately before it appreciates, he or she would owe no capital gain on the sale. The child is only responsible for capital gains that accrue after he or she inherits the stock. If the child holds the stock until it appreciates to $15,000, the child would owe capital gains on $5,000, or the gain they realized when they owned the stock themselves.

Income tax basis planning

By making a lifetime gift, you may (perhaps unknowingly) place an additional tax burden on your child. For estate planning strategy purposes, consider an asset’s basis. It’s more beneficial for you to make lifetime gifts of assets with a high basis (little appreciated value) or cash. In that case, the asset avoids the estate tax and, since the asset has not appreciated significantly, avoids significant capital gains tax. On the other hand, low basis assets should be held until death in order to reduce the capital gains burden on the recipient.

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