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Income Tax Planning Is the New Estate Tax Planning

For decades, minimizing estate taxes was a top priority for anyone with substantial assets. Now, with the estate tax exemption at an all-time high of nearly $5.5 million, estate tax concerns are limited to the most wealthy Americans.

On the other hand, income taxes are higher than they’ve been in decades. In 2013, the highest income tax rate increased to 39.6%, the highest tax rate on capital gains and dividends increased to 20%, and a 3.8% surtax on investment income was added.

For most families, these changes have resulted in an increased income tax burden and a decreased estate tax burden. While income tax planning is often limited to yearly income tax returns, estate planning can be a powerful tool to reduce a family’s intergenerational income tax burden.

Below are some strategies you can use to minimize your family’s income taxes through your estate plan.

Hold on to Highly-Appreciated Assets 

A little-known tax rule (the step-up-in-basis rule) eliminates capital gain tax on inherited assets. This rule can benefit families with modest estates who own a home that was purchased long ago, as well as families with more significant assets who hold real estate investments or highly-appreciated stock. 

A common estate planning mistake when it comes to income taxes is to transfer assets to children or other beneficiaries prior to death. While transferring assets during your life can be beneficial for Medicaid planning and can simplify the administration of your estate, it can be a disaster when it comes to income taxes. (For related reading, see: Get a Step up With Credit Shelter Trusts.)

Suppose you purchased a vacation home 30 years ago for $50,000, and the property is now worth $500,000. In order to qualify for Medicaid, you decide to transfer ownership of the house to your daughter. If your daughter sells the house after few years, she would have to pay capital gains taxes of up to 23.8%. If, instead, you held on to the house and your daughter inherited it, she would owe no capital gains tax on its sale—a savings of over $100,000! This result can also be obtained by transferring the house to a Medicaid trust or retaining a life estate in the property.

Allocate Retirement Accounts to Beneficiaries in Lower Income Tax Brackets

The rules that apply to inherited retirement accounts present ample opportunity to maximize tax deferral and minimize income taxes for beneficiaries. Below are three rules of thumb to minimize taxes for your heirs with retirement account planning.

  • Leaving an account to a younger beneficiary provides for longer tax deferral because a younger beneficiary can leave funds in the account for a longer period of time.
  • Leaving an account to a beneficiary in a lower income tax bracket results in lower taxes upon withdrawal because the withdrawals are subject to the beneficiary’s income tax rate.
  • Leaving an account to charity eliminates any taxes on the account. (For related reading, see: Gifting Your Way to Lower Estate Taxes.)

Create a Family Limited Partnership

Family limited partnerships can be a great way to reduce your family’s overall income tax burden. This strategy works particularly well with family businesses or real estate holdings.

Income generated by a partnership is allocated among the partners, even if the income remains in the partnership and isn’t paid out to the partners. By aggregating your assets in a partnership entity (usually a limited partnership or a limited liability company) and transferring interests in the partnership to members of your family who are subject to lower income tax rates, you can lower your family’s overall tax bill. 

One catch—and it’s a big one—is that once you transfer the partnership interests, they’re gone. You can’t take them back, so this strategy should only be undertaken as part of your overall estate and financial plan. (For related reading, see: Using an LLC for Estate Planning.)

Create a Self-Settled Non-Grantor Trust

Individuals who live in states with high taxes can feel especially burdened by combined federal and state income taxes. If you live in a high-tax state, you might benefit from creating a self-settled asset protection trust in an asset-protection jurisdiction like Delaware or Nevada. These trusts can shield assets from taxes on capital gains that would otherwise be imposed by your home state. They have the added benefit of protecting your assets from creditors.

To illustrate how this strategy works, suppose a New York business owner plans to sell her business. The sale would be subject not just to federal capital gains taxes, but also to New York State taxes. If the business owner transfers his or her interest in the business to a self-settled Delaware trust, the trust can sell the business free of state capital gains taxes, resulting in thousands or potentially millions of dollars in taxes at the state level.

Note that this strategy requires giving up control of the asset, with restrictions on accessing any proceeds of the sale, so it’s best to limit its use to assets that you won’t need for retirement and plan to pass on to your children or other beneficiaries.

(For more from this author, see: Estate Planning Tips for Multinational Families.)