Modern Estate Planning: Strategies for Minimizing Estate and Income Taxes

By Elle Van Dahlgren, Esquire

September 3, 2024

Estate planning has undergone significant changes over the last 25 years. Understanding these changes is essential to help your heirs receive the maximum value from their inheritance. If you have an estate plan that is more than 10 years old or a trust you inherited from someone, it is probably time to review your estate plan with an attorney to find ways to minimize your heirs’ taxes on their inheritance.

Federal Estate Tax Planning

The biggest taxation difference in estate planning relates to the federal estate tax exemption amount (“exemption”). This is the threshold amount after which the IRS says your heirs must pay the 40% federal estate tax.  In 1998, the exemption was $625,000 per person. This means that if you had more than $625,000 in assets (including real estate, retirement plans, investment accounts, life insurance death benefits, and all other assets you own), your heirs had to pay the 40% estate tax on all assets over $625,000. Many people’s assets exceeded this amount, particularly when adding in life insurance death benefits, which means estate plans in 1998 and the early 2000’s focused on avoiding this tax. 

By contrast, in 2024, the exemption is $13.61 million per person. Very few people meet this threshold, which means planning to avoid estate tax does nothing to benefit their heirs. Rather, their estate plan should focus on minimizing income tax for the heirs since that will factor into at least some (if not all) of a person’s inheritance.

Shifting Focus to Income Tax Planning

There are two main aspects of estate planning to minimize income tax liability: basis step-up and planning for taxation of IRAs, 401(k)s, 403(b)s, and other qualified retirement accounts. This article focuses on the issue of basis step-up, which applies to every person’s estate plan (including yours).

What is basis step-up? An asset’s basis is how the IRS calculates capital gain tax. This term applies both when you are living and after your death.  Here is an example:

You purchased a vacation property[1] 25 years ago for $200,000. The property is currently valued at $500,000.  If you sold the vacation property today, you would pay capital gains tax on the $300,000 growth in value over the last 20 years.

Basis step-up comes into play at the owner’s death. Using the same vacation property example:

If the property was valued at $500,000 at the time of your death, and your heirs sold the property for $600,000, they would only pay capital gain tax on $100,000 – or the amount the property increased after your death. Obviously, this can result in significant tax savings since $300,000 of gain essentially “disappears.”

How do you lose the basis step-up? There are two common ways people lose the benefit of the basis step-up in their estate plans: bypass trusts and joint ownership. 

Many estate plans in the early 2000’s created trusts for the benefit of a surviving spouse or other heirs. These were usually called a “Bypass Trust” or a “Family Trust.” If your asset (in this example, the vacation property) is owned in that Bypass Trust at the time of your death, then your heirs do not receive the basis step up. Rather, they pay capital gains on all increase in value of the property after the death of the person who created the trust. Dissolving these types of trusts can be an important aspect of updating an estate plan and save heirs thousands – if not tens of thousands of dollars.

A similar loss of tax savings occurs if you add your heirs as a co-owner on the asset. In our example of a vacation property, this would mean adding an heir as a joint owner of the property. Many people think this will simplify the process of transferring assets to their heirs after their passing. However, by doing this, your heirs lose a portion of the basis step up, therefore increasing the amount of capital gain tax they must pay. If they had inherited the property from you rather than be added as a joint owner, your heirs would have the benefit of the full basis step-up and save significant income taxes when they sell the asset.

Conclusion

As you can see, the tax focus in estate planning for the vast majority of people has shifted away from minimizing estate tax and instead focuses on minimizing income tax. Without reviewing (and possibly updating) your estate plan, your heirs may lose valuable tax benefits when they inherit your assets.

[1] Different capital gain rules apply to a primary residence. Individuals do not pay capital gain tax until they have $250,000 in increased value on their primary residence at the time they sell the property. Married couples do not pay capital gain tax for their primary residence until they have $500,000 in increased value at sale of the property.

To make an appointment, please contact Elle Van Dahlgren Law, LLC by calling 302-407-5009 today.