Understanding the Financial Basics of Wealth Transfer
Before diving into specific strategies, it is essential to understand a few key terms. The U.S. tax system has specific rules for giving away assets, both during your life and after you pass away. Fortunately, these rules are more generous than most people realize.
The Gift Tax and the Annual Exclusion
The gift tax is a federal tax on the transfer of money or property to another person while getting nothing (or less than full value) in return. This sounds scary, but the vast majority of people will never pay it. This is because of the annual gift tax exclusion.
For 2024, you can give up to $18,000 to any single individual without having to pay any tax or even file a gift tax return. This is a “per person, per year” exclusion. If you are married, you and your spouse can combine your exclusions.
Example: You and your spouse want to help your daughter and her husband. In a single year, you can give your daughter $18,000, and your spouse can also give her $18,000, for a total of $36,000. You can do the same for her husband, giving them another $36,000. In total, your family can transfer $72,000 to them in one year, completely tax-free.
The Estate Tax and the Lifetime Exemption
The estate tax is a tax on your right to transfer property at your death. Like the gift tax, it affects very few Americans. This is due to the very high lifetime gift and estate tax exemption. This is the total amount you can give away during your lifetime and at your death before any taxes are owed.
For 2024, the federal lifetime exemption is $13.61 million per individual. For a married couple, this amount doubles to over $27 million. This means that unless your total estate is worth more than this amount, your heirs will not owe any federal estate tax. While some states have their own estate or inheritance taxes with lower thresholds, the federal tax is not a concern for most families.
The Critical Concept: Cost Basis vs. Stepped-Up Basis
This is perhaps the most important concept for seniors to understand when it comes to transferring assets like stocks or real estate. It can save your children tens or even hundreds of thousands of dollars in taxes.
- Cost Basis: This is essentially what you paid for an asset. If you bought 100 shares of a stock for $10,000, your cost basis is $10,000.
- Stepped-Up Basis: When you pass away and your heirs inherit an asset, its cost basis is “stepped up” to its fair market value on the date of your death.
Example: Let’s say you bought a house in 1980 for $50,000. Today, it is worth $450,000.
- If you give the house to your son today, he also receives your original $50,000 cost basis. If he sells it for $450,000, he has a taxable capital gain of $400,000 ($450,000 sale price – $50,000 cost basis). He could owe over $80,000 in capital gains taxes.
- If your son inherits the house from you after you pass away, the cost basis is stepped up to the current market value of $450,000. If he turns around and sells it for that price, his taxable gain is $0 ($450,000 sale price – $450,000 stepped-up basis). He owes no capital gains tax.
This single rule is why, in many cases, it is far more tax-efficient for your children to inherit appreciated assets rather than receive them as gifts.
