Five Ways To Solve the Estate-Tax Trap

Question: I am 78 years old and have seen my wealth grow nearly 25% in recent years. I can’t spend it all, but I also don’t want to pay capital-gains tax. Is there anything I can do?

Answer: This is a classic estate-tax trap. If you gift your heirs highly appreciated securities, you also pass on the basis—and with it, the capital-gains liabilities. On the other hand, if you wait to pass the securities through your estate, they receive a step-up in basis, which eliminates the capital gains tax. However, it could be years before your heirs can access their inheritance.

There are several strategies to navigate this issue:

Sell the stock and pay the gains: Simply paying the capital gains taxes upfront could benefit your heirs in the long run. Any taxes you pay reduce the size of your estate, and thus, the eventual estate tax. For example, if you sell $1 million of stock with a $500,000 basis, and assuming a federal tax rate of 23.9% and a state tax rate of 5%, you will pay a capital gains tax of $144,500 ($500,000 x 28.9%). This in turn reduces your estate by $144,500, which lowers the estate tax by $57,800 ($144,500 x 40%), making the net cost to your heirs $86,700 ($144,500 – $57,800). By selling, your heirs also gain immediate access to the proceeds.

Gift the appreciated asset: If your heirs have incomes under $47,000, they pay no capital-gains tax on the sale of the asset. For example, if your grandchild is a freshman in college earning $7,000 annually from part-time work, you could gift them $320,000 worth of stock with $160,000 in gains. They could sell approximately a quarter of it each year while in college and pay no capital-gains tax. The catch is the funds would need to be given directly, not gifted into a trust.

Gift from a Roth IRA: Distributions from a Roth IRA can be tax-free, avoiding both income and capital gains taxes. While this removes the tax-free returns in the Roth prematurely, the current rules generally require heirs to withdraw all funds from a Roth within 10 years of the account holder’s death. This reduces the long-term return of the Roth assets, but it may be more cost-effective than recognizing capital gains now.

Use charitable donations to offset gains: Donating appreciated securities to a family foundation, donor-advised fund or other qualified charity can eliminate the capital-gains tax on the donated securities. Additionally, you may receive a charitable deduction to offset other capital gains. If you already have philanthropic goals, this strategy can allow you to shelter the capital gains while funding future charitable endeavors.