Income tax and estate tax: While they seem unrelated, understanding how they intersect is critical for your financial health (and that of your heirs). In this blog, we dive into the essentials of both, highlighting the importance of strategic planning in maximizing your legacy and minimizing your loved ones’ tax burden.

Estate Tax: The Essentials

What is estate tax?

Federal estate tax is a tax levied on the transfer of a deceased person’s estate. The “estate” includes everything the individual owned or had interest in at the time of passing, including cash, securities, insurance policies, business interests, and more.

How is the tax applied?

Someone’s “gross estate” refers to the total dollar value of their assets. After subtracting any liabilities and applicable deductions, you arrive at the “taxable estate.” If the taxable amount exceeds the 2023 $12.92 million gift and estate tax exemption, a progressive rate is applied to the excess, and the amount due is deducted from the estate itself. To report this, the estate’s or trust’s personal representative must file an estate tax return, Form 706.

When is the tax applied?

If the taxable estate is above the threshold, Form 706 should be filed no more than nine months after the owner’s passing. If the estate generates annual income before being transferred to its beneficiaries, Form 1041 must be submitted by the 15th day of the fourth month after the estate’s fiscal year ends.

Income Tax: The Essentials

What is income tax?

Income tax is a tax on an individual’s or entity’s earnings, including employment wages, profits from investments, and income earned from various other sources. Down the road, your beneficiaries’ income tax returns may also include capital gains realized from the sale of assets they inherit. Note: This shouldn’t be confused with inheritance tax, which only some states impose on beneficiaries.

How is the tax applied?

Federal income tax is progressive, meaning you progress into higher tax brackets as your income increases. Income also determines whether long-term capital gains are taxed at a 0%, 15%, or 20% rate. Short-term capital gains (profits from assets held for a year or less) are usually subject to regular income tax rates.

When is the tax applied?

Every tax year, individuals must file their income tax return (Form 1040) and pay any taxes owed, usually by April 15th. Capital gains are generally reported on Schedule D, a form filed alongside Form 1040.

Estate Planning & the Step-Up in Basis

The step-up in basis is a tax provision everyone should be aware of, especially when estate planning. Let’s say an individual named Jane purchases a property for $200,000, and at the time of her death, it’s worth $500,000. The cost basis (original value) gets “stepped up” to the market value at the date of death. So, if Jane’s heir sells the property for $540,000, they only pay capital gains tax on the $40,000 gain, not on the $340,000 gain from the original purchase price.

This provision can lead to substantial tax savings for heirs, but it’s a double-edged sword. Assets that receive a step-up in basis can minimize your loved ones’ tax liability, but they may increase the estate’s value, possibly subjecting it to higher estate taxes. Conversely, you may gift assets during your lifetime to reduce the size of your taxable estate. However, these gifted assets don’t benefit from the step-up in basis for income tax purposes, which means your heirs may owe more whenever they choose to sell.

Finding the Right Strategies

So, how do you decide which assets to gift versus keep in your taxable estate? This is where Ironwood Wealth Management can help. With our expertise, you can develop strategies that maximize the benefits of tax-free gifting and the step-up in basis, minimizing your heirs’ potential tax liabilities.

Learn more about how our financial planning services can help you navigate the intricacies of estate tax planning and secure your financial legacy.