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Estate planning usually involves determining how assets should be passed on to younger generations. But instead of leaving a piece of real estate, a bank account, or a growing stock portfolio to your children, it might be smarter to leave those assets to your parents.
That’s the core of a smart tax minimization strategy known as “upstream gifting,” as Charles Schwab highlighted. The strategy revolves around increasing the basis given to assets inherited by heirs. The idea is to reverse the flow of an estate’s valuable assets from ‘downstream’ – to generations of children and grandchildren – by taking advantage of the shorter life expectancy of older, ‘upstream’ generations.
A financial advisor can be a valuable resource as you plan your estate. Find and speak to a financial advisor today.
Upstream gifting is a strategy to expedite the transfer of highly valued assets to children while limiting the taxes owed on the inheritance.
Instead of giving assets directly to your children while you are still alive or leaving them in your will, you can transfer the assets to a living parent or grandparent. In turn, they leave these assets to your children when they die, preserving the increase in basis and saving your children in taxes.
However, this tax trick doesn’t work with inherited IRAs or other tax-deferred assets. The same applies if the upstream recipient of the asset has an extremely large estate, Schwab said. However, it can be extremely helpful in reducing the tax burden on highly valued assets and expediting the transfer of assets to children.
It’s all a bit complicated, but that’s how the tax strategy works in theory.
Loretta invests $1 million in a stock portfolio that grows to $5 million in value with an annual gain of 5% per year. If Loretta sells the stock now, she will be taxed on the $4 million gain above her $1 million cost basis. If she gives the stock to her son Rich, the basis remains $1 million because the gift was made during her lifetime, giving him no tax benefit. In other words, when Rich sells the stock, he will owe taxes on the $4 million in profits the portfolio generated during his mother’s lifetime.
If Loretta lives another twenty years and leaves the shares to Rich after her death, the shares would be worth $13.3 million. Rich would receive an increase in basis and would not owe taxes on the prior gains. However, this would leave the $13.3 million in assets in Loretta’s estate, potentially triggering expensive estate taxes.
Instead of leaving the shares to Rich in her will, Loretta uses upstream donations and gives the current share value of $5 million to her father, Al. Four years later, when the value of the stock has grown to $6 million, Al dies and leaves the assets to Rich in his will. Rich’s tax basis for the stock now stands at $6 million.
When Loretta dies 16 years later, the stock is worth $13.3 million. But since she no longer owns these assets, her total assets are now worth $16.7 million, instead of $30 million if she had kept the stock portfolio. This reduces her theoretical estate tax from $16.39 million to just $3.09 million (assuming the 2024 estate tax exemption of $13.61 million).
In addition, Rich has enjoyed $250,000 in annual income from the stock portfolio for 16 years without having to sell shares. Additionally, the entire $4 million of that income is taxed at the lower capital gains rate instead of the regular income tax rate.
Keep in mind that this is too simple an example and that inheritance taxes can become complicated, especially as legislation changes over time. Consider a match with a financial advisor who can help you navigate your own situation.
The estate planning process should take into account all available options when it comes to easing taxes and increasing the size of any inheritances. Going outside normal inheritance plans and gifting assets upstream can potentially accelerate the transfer of assets from one generation to the next, resulting in a large reduction in estate taxes.
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A financial advisor may be able to help you answer important questions about your estate plan, including trusts, gifts and other considerations. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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