Two Things You Need to Know About Transferring Wealth

An important part of stewardship involves being efficient with our assets and minimizing waste.  Often I find that people concentrate on saving nickels and dimes in their daily lives, but ultimately ignore the things that could potentially save them and their heirs hundreds of thousands of dollars.  It’s important to be wise when it comes to making the most of our income, but we should also seek out opportunities that make us more efficient with the resources we’ve already accumulated.

Let’s first address the broader issue of taxes.  Jesus made it pretty clear that we are not to evade paying them. In Mark 12:17, “Jesus said to them, ‘Render to Caesar the things that are Caesar’s, and to God the things that are God’s.’”

If we owe taxes, we should be obedient to the government that God has established over us and pay them.  That being said, we don’t need to go out of our way to pay more than we owe.  The IRS code has provided us with opportunities to reduce our tax liability by taking certain actions.  For example, we receive tax benefits for giving to charity and contributing to our retirement accounts.  The IRS gives us the incentive to support charities because those non-profit entities can efficiently provide services (with the help of volunteers) that the government would otherwise need to fund at a higher price.  In regards to our retirement plans, they give us the incentive to save in order to reduce the likelihood that the government will need to support us during our retirement years.  When these incentives get us to take action, it’s a win-win for us and the government.

Unfortunately, it’s going to be impossible for the average person to understand the nearly 75,000 pages of the IRS tax code to take advantage of all the provisions that might help us.  However, I want to focus on two specific tax situations that when understood can make a sizeable difference when passing assets to our heirs and to charity.

1.  Step-Up in Basis – The term “cost basis” refers to the original value of an asset for tax purposes.  This is often simply the purchase price, but it can be adjusted in certain situations.  The difference between your cost basis and the selling price of an asset is called a capital gain and is taxed at its own special rate.  So, let’s say we purchase a stock for $100 and later sell it for $150, the $50 increase in value is taxed as a capital gain.

Things start to get a little more interesting when assets are transferred from one person to another.  We’ll take a look at what happens when an asset is gifted during a person’s lifetime and when it is passed to another person at death.

Lifetime Gift – When an appreciated asset is gifted to another during the lifetime of the owner, the original cost of the asset also passes to the recipient.  That also means that any capital gains also pass to the new owner.  Therefore, there will be tax to pay on that gain if the asset is later sold.

Transfer at Death – The process is significantly different when the owner passes away and transfers ownership to their heirs as an inheritance.  Instead of the original cost basis transferring with the asset, in this situation the asset typically receives what is called a step-up in basis.  This means that the cost basis of the asset is reset at the time of inheritance to the current market value at that time.  This can be a huge benefit to the recipient because all untaxed gain that has accumulated since the time it was originally purchased has now been wiped away.  When the new owner decides to sell the asset, only gains during their time of ownership will be subject to capital gains tax.  This process also provides a record-keeping benefit since the new owner doesn’t need to dig through old records to determine the original purchase price.  Instead, the tax process has been simplified by using current value to reset the tax calculation for the new owner.

Application

The step-up in basis process may not seem like a very big deal, but it does have major implications when it comes to estate planning.  Take a farmer for example.  Let’s say the farmer owns land that he originally purchased for $100,000 and is currently valued at $2,000,000 (around a 6% annual growth over 50 years).  If the farmer sold his land today, he would owe taxes on the $1,900,000 of capital gains he has in his property.  If we assume a 20% tax rate, he would owe $380,000 of capital gains tax.  This will likely make the farmer think twice about selling the land.

If the farmer decides to gift the land to his children while he’s living, they will not receive a cost basis adjustment and all the untaxed gain will also transfer to them.  As a result, they will owe capital gains tax on any amount above $100,000 if they eventually decide to sell it.  As you can see from this example, it’s important to get advice when making lifetime gifts to your children.

If the farmer holds onto the land and passes it to his children at death, all the prior capital gains will be wiped away for his children because of the step-up in basis process.  The heirs will only owe taxes on appreciation above the value of the land as determined by his estate if they decide to later sell it.

The benefit of the cost basis reset is so large in this situation that the farmer needs to consider all options if he needs money during his life.  Depending on the situation, he may find options that serve his family better than selling his land and paying the taxes.

2.  Income in Respect of a Decedent (IRD) – Don’t let the long name scare you.  IRD simply refers to income that was owed to the person that is now deceased and is therefore going to have income tax due on it.  One of the biggest issues related to IRD tax involves inherited IRAs, 401ks and annuities.

Unlike the step-up in basis that is given to some assets, retirement accounts do not receive a tax reset at the time they are inherited.  Instead, the new owner will also inherit the tax situation of the original owner on all distributions taken from the account.  So, for most people who inherit a traditional IRA or 401k, 100% of any distribution will be taxed as ordinary income.  Current federal income tax rates go as high as 39.6% and there may be state taxes due as well.  The impact of these taxes will cause your heirs to net a significant amount less than the full account value.

Application

While naming our children as beneficiaries of our retirement accounts is an easy thing to do, the tax impact can make these accounts some of the least tax-efficient assets to pass to our heirs.  For those who are interested in leaving estate gifts to charity, these retirement plans can be some of the best assets for that purpose.  If the charity is a tax-exempt entity, they will get to keep 100% of the proceeds because they avoid paying income tax on the distribution.  So, instead of your children only receiving a portion of the account value with the rest going to taxes, the charity is able to benefit from the entire account value.

Unfortunately, many people don’t consider these tax rules and end up naming their children as the beneficiaries of their retirement plans or annuities without much thought and then give an asset that receives a stepped-up basis (stock, real estate, etc.) to charity.  Because of the large value of many estates, the money going to taxes instead of ministry can often be well into the six figures.

Conclusion

Estate planning is a very complex topic and there are many details to consider.  This article in no way provides you with all the information you need to make wise decisions.  However, reading about a few of the possibilities will hopefully help you realize the importance of proper planning.  While it may not be the most enjoyable of discussions, the impact of our efforts can be quite large and will hopefully serve as a blessing for both our children and God’s Kingdom.

Brad Graber, CFP® has been working with clients on personal financial planning and investment issues since 1996.  He invests his time mentoring and educating individuals on ways to be better stewards of the resources God has entrusted to them.

***Disclaimer:  The estate planning and tax information contained in this article is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice.  I am not an attorney or accountant and cannot guarantee that such information is accurate, complete, or timely. Federal and state laws and regulations are complex and subject to change.  You should consult an attorney or accountant regarding your personal legal and tax situation.