By Neal Templin
April 22, 2024
Suppose you have a $3 million brokerage account and a $3 million tax-deferred retirement account. You plan to leave half of your estate to your daughter, a successful attorney, and the other half to charity.
So you decide that your retirement account will go to your daughter, who is already listed as a beneficiary, and the brokerage account will go to the Salvation Army.
You have just committed a tax faux pas, and it’ll cost your high-earning daughter a lot of money.
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Your daughter, who already is in a high tax bracket under her salary, will pay tax on every dollar she pulls out of the retirement account. Yet if you had left her the brokerage account, she would inherit it tax-free.
The Salvation Army, meanwhile, won’t pay taxes in either case—whether it receives the retirement account or the brokerage account.
How much would this mistake cost? The daughter would pay close to 50% of the value of the tax-deferred account in taxes if she lives in a high-tax area like New York City, said Greg Will, a certified public accountant and financial advisor in Frederick, Md.
“Nearly $1.5 million of that $3 million will go to taxes,” he said. “But in the alternative scenario were she to receive the $3 million brokerage account, she would get the full $3 million.”
This scenario isn’t an anomaly. David Frisch, a CPA and financial advisor in Melville, N.Y., regularly encounters clients who are giving the wrong money to charities. “So many times it’s just done backward,” he says. “And if you explain it to them, they say, ‘Oh my God, I want to change it.’”
At issue is something called stepped-up basis. Certain assets, including stocks, real property, collectibles, businesses, and cryptocurrencies, are stepped up to their value on the day of the owner’s death. So if your father bought shares of Southwest Airlines for a pittance in the 1980s and they’re now worth $1 million, they are stepped up to $1 million upon his death. You could sell them the next day and not pay capital gains.
Other assets, including retirement accounts and tax-deferred annuities, aren’t stepped up in value. So your heirs will more or less owe the same taxes—depending on their tax bracket—as you do. They aren’t getting a tax break upon your death.
Does that mean you shouldn’t leave a tax-deferred retirement account to your children? Of course not. Even after taxes, they will derive a significant benefit from it. But if you are charitably inclined, you should first donate the assets that don’t get stepped up in value at your death.
The concept of step-up value isn’t just important when it comes to charity. It’s also important to remember when giving real estate to your heirs.
Greg Will, the CPA, dealt with a situation where his clients had a $2.5 million beach house in New Jersey that they had bought long ago for very little. “They had gifted some small percentages of the house over many years to their children, thinking they would save on estate taxes,” he explained. The children had almost a 50% interest in the house by the time the CPA got involved.
The problem was that New Jersey had done away with its estate tax, and the federal government expanded its estate tax exclusion to more than $12 million, far bigger than the couple’s estate. The bottom line was this couple wouldn’t owe any estate taxes under current laws, so their whole strategy accomplished nothing.
It did have one unwelcome consequence: Because the children had acquired a half interest in the house, only half of its value would be stepped up in value upon the death of the parents. The children would needlessly owe hundreds of thousands in capital gains if they sold the house, Will said.
In this case, the family’s estate planning attorney found the gifts had been done improperly, and she was able to undo them so that the children had no ownership in the house, Will said.
Parents sometimes give away houses while they are alive so the real estate won’t have to go through the hassles of probate upon their death. They lose the stepped-up basis when they do so.
Parents can avoid probate and retain step-up for their heirs by creating a revocable trust for their real estate, Frisch, the New York CPA, said. Upon death, the trustees—presumably the children—can take control of the house without going through probate, but they won’t owe taxes on its previous capital gain. They will, however, need to get the home appraised to establish its value at the “date of demise,” Frisch said.
Depending on your health and cash, one tax-efficient way of passing money to your children can be buying life insurance, Frisch said. Life insurance isn’t taxable so your children should receive the money tax-free unless the estate is larger than the federal or state exclusion.
By contrast, Frisch noted, with an inherited 401(k), “every nickel will be taxed as ordinary income.”
Write to Neal Templin at neal.templin@barrons.com
This Barron's article was legally licensed by AdvisorStream.
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