This Gifting Strategy Could Keep More of Your Estate in the Family

Upstream gifting is a tax and estate planning strategy that calls on giving highly-appreciated assets to someone in an older generation, who in turns leaves the assets to the original owner's children. — Upstream gifting is a tax and estate planning strategy that calls on giving highly-appreciated assets to someone in an older generation, who in turns leaves the assets to the original owner’s children.

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Estate planning usually involves determining how to pass assets on to younger generations. But instead of leaving a piece of real estate, bank account or burgeoning stock portfolio to your children, the smarter tax move might be to leave those assets to your parents.

That’s the crux of a clever tax minimization strategy known as “upstream gifting,” which Charles Schwab highlighted. The strategy revolves around the step-up in basis that’s given to assets inherited by heirs. The idea is to reverse the flow of an estate’s valuable property from going “downstream” – to generations of children and grandchildren – by leveraging the shorter life expectancy of older, “upstream” generations.

A financial advisor can be a valuable resource as you plan out your estate. Find and speak with a financial advisor today.

Upstream gifting is a strategy for expediting the transfer of highly appreciated assets to children, while limiting the taxes that will be owed on the inheritance.

Instead of giving assets directly to your children while you’re still alive or including them in your will, you can transfer the property to a living parent or grandparent. In turn, they leave those assets to your children when they die, preserving the step-up in basis and saving your children on taxes.

This tax trick won’t work with inherited IRAs or other tax-deferred assets, though. The same is true if the upstream recipient of the asset has an extremely large estate, according to Schwab. However, it can be especially useful to cut the tax bill on highly appreciated assets and expedite the transfer of assets to children.

A woman and her father go over her estate plan with an estate planning attorney.

It’s all a bit complicated, but here’s how the tax strategy works in theory.

Loretta invests $1 million in a stock portfolio that grows to $5 million in value with annual gains of 5% each year. If Loretta sells the shares now, she’ll be taxed on the $4 million gain beyond her $1 million cost basis. If she gives the stock to her son, Rich, the basis will remain $1 million because the gift was made during her lifetime, giving him no tax advantage. In other words, when Rich sells the stock he’ll owe taxes on the $4 million in gains the portfolio generated during his mother’s life.

If Loretta lives another 20 years and leaves the stock to Rich when she dies, the stock would be worth $13.3 million. Rich would receive a step-up in basis and wouldn’t owe taxes on any of the previous gains. However, that would leave the $13.3 million in assets in Loretta’s estate, potentially triggering costly estate taxes.

Instead of leaving the stock to Rich in her will, Loretta uses upstream gifting and gives the $5 million in current stock value to her father, Al. Four years later, when the stock’s value has grown to $6 million, Al dies and leaves the assets to Rich in his will. Rich’s tax basis for the stock now is $6 million.

When Loretta dies 16 years later the stock is worth $13.3 million. But since she no longer owns those assets, her total estate is now worth $16.7 million instead of $30 million had she held onto the stock portfolio. This lowers her theoretical estate tax liability 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 any shares. Plus, 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, this is an oversimplified example and estate taxes can get complicated, especially with legislation changes over time. Consider matching with a financial advisor who can help you navigate your own situation.

The estate planning process should consider all available options when it comes to mitigating taxes and boosting the size of eventual inheritances. Going outside of the normal inheritance plans and gifting assets upstream can potentially expedite the transfer of assets from one generation to the next and produce a big cut in estate taxes in the process.

A financial advisor can potentially help you answer important questions concerning your estate plan, including trusts, gifts and other considerations. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost 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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