Taxes, Inheritance, and Death Bed Planning

When it comes to the transfer of assets after death, tax planning should always be at the forefront of both the benefactor and beneficiaries’ minds. From capital gains taxes to potential estate taxes to ordinary income taxes, these burdens can put a significant dent in a spouse or child’s inheritance.

While the death of a spouse or a loved one is never an easy topic to address, some situations in life warrant these types of tough discussions. When spouses have different life expectancies, say an older husband and a younger wife, or if a parent or spouse becomes terminally ill, the following death bed planning strategy can help to alleviate some of the taxes assessed on the transfer of unrealized gains and losses.

In deathbed planning, the healthy spouse transfers all the highly appreciated stock in their taxable accounts to the sick or elderly spouse. When the sick spouse passes away, their widow/er gets a full step-up in basis on the value of the asset and will therefore owe no taxes upon the death of their spouse.

Understanding Inheritance and Tax Law

Current tax law dictates that when an appreciated asset is transferred as part of an inheritance, the value is readjusted to the higher market value for tax purposes. This is referred to as the ‘step-up in basis[i].’ With an appreciated asset, the step-up value is higher than when the original owner acquired it. The step-up can significantly decrease the amount of capital gains that will be taxed.[ii]

Essentially, this means that the asset passed to the beneficiary is worth more now than it was when the original owner acquired it. Thus, when the asset is transferred at death, it receives a step-up in basis to help minimize the capital gains tax[iii] paid by the beneficiary. 

Capital gains tax[iv] applies to the growth in value of assets and investments, and the tax is incurred when the investment is sold. This situation most often applies to assets like stocks and bonds, but in this case, it also applies to assets gained through inheritance. Say, for instance, that your grandmother purchased a diamond ring for $1,000 in the 1950s, and you inherited it when she passed away in 2015. At the time of her passing, the ring has increased in value to $6,000, but in 2021 you decide to sell it, and it’s valued at $8,000. So the ‘basis’ of the ring is $1,000.

Because the asset has increased in worth, it is subject to capital gains tax. Since you held onto the ring for six years, it is considered a long-term capital gain and taxed at a rate of up to 20%, compared to a short-term gains rate of up to 37%. Fortunately, because it was inherited, the asset is also subject to a step-up in basis: you’ll only pay capital gains tax on the $2,000—the increased value between 2015 and 2021—rather than the original ‘basis’ value from the 1950s. 

The step-up in basis will save you as the beneficiary a significant amount of money if and when you choose to sell the asset. This provision is currently enshrined in Section 104 of the Internal Revenue Code[v].

A Change on the Horizon?

However, things may be changing[vi] in the not-so-distant future. Hidden away in President Biden’s American Families Plan, there is a proposal to change the laws surrounding capital gains taxes and inherited assets. It’s no cause for panic, though, as the bill is far from becoming law. Nevertheless, we feel it’s important to understand potential changes that may be coming down the pike, what they may mean for you, and how you can prepare yourself and your loved ones.

Biden’s tax reform plan[vii] includes—among other things—doing away with a step-up in basis for individual capital gains of $1 million or more (and $2 million or more for married couples). According to the feds, the plan is intended to target billions in capital gains that would, without the change, evade taxation entirely.

Of course, if this bill does go through, it will directly affect spouses who partake or plan to partake in deathbed planning. So how can you protect yourself against Biden’s potential changes to tax law? 

You may want to consider an ongoing strategy called ‘basis management,’ which strives to bring down gains in portfolios. It may mean keeping a closer eye on annual rebalancing, placing stocks that you expect to appreciate into retirement accounts, transferring low-basis stocks to family members with lower household incomes, charitable giving, gifting, and more. You may also want to investigate transferring financial losses from the sick spouse to the healthy spouse to offset gains.

Although death and taxes are inevitable, there are ways to ease the financial burden of loss. If you or a loved one think you may benefit from this strategy, we encourage you to reach out the us at URS Advisory. We always keep tax planning at the forefront of our minds in order to preserve more of our clients’ wealth.

Schedule a complimentary initial conversation with one of our URS Advisory financial advisors today to learn more. We work locally with individuals, couples, and retirees on the Treasure Coast and in the Palm Beaches. We look forward to meeting you.

[i] 10 June 2021

[ii] 10 June 2021

[iii] Ibid.

[iv] 10 June 2021

[v] 10 June 2021

[vi] 10 June 2021

[vii] 10 June 2021