Balancing Income and Estate Taxes: How to Make Tax Smart Decisions When They Intersect

12.15.2021 - Bryan Kirk, Director of Estate and Financial Planning and Trust Counsel

Maximizing wealth during your lifetime and then tax-efficiently transferring it to future generations—these two goals are at the heart of financial and estate planning. To achieve them, however, you’ll need to find an optimal balance between the two taxation systems that govern wealth: income taxes and transfer taxes (gift/estate).

But income taxes and transfer taxes can act like opposite ends of a seesaw when trying to develop a long-term financial and estate plan.

Two Avenues of Taxation

Income taxes

During your lifetime, federal income tax applies to your wages, interest, dividends, capital gains and other income each year. Depending on where you live, state and local income taxes may also apply.

Today, federal ordinary income tax rates go up to 37%. If you sell an asset at a profit or receive qualified dividends, federal long-term capital gains rates typically apply at either 15% or 20%, depending on your taxable income. There’s also a 3.8% federal net investment income tax that may apply on top of either tax if your income exceeds the thresholds. And, under the proposed tax bill beginning in 2022, there may be a surcharge of 5% on modified adjusted gross income (MAGI) on individuals above $10 million and an additional 3% on MAGI above $25 million.

The good news on capital gains tax is that any unrealized gains disappear when you leave an asset to someone at your death. This means when your beneficiaries sell the assets, they will only be taxed on any gains that took place after your death, since the cost basis is “stepped-up” at that time.

Gift and Estate Tax

Gifts you make during your lifetime and assets passed to heirs at your death are subject to a different set of tax rules. For the 2022 tax year, individuals are entitled to a $12.06 million ($24.12 million for married couples) gift and estate tax exemption. Any assets transferred beyond the exemption amount are subject to a 40% federal estate tax. In addition, a separate federal tax, called the generation-skipping transfer tax, can apply to gifts to grandchildren or lower generations over the exemption. State gift, estate and inheritance taxes also apply in certain states.

Of course, these are the rules today. Recent history has shown change is regularly in the air, and not always in ways you might expect. With long-term financial and estate planning, you need to consider the two tax systems as they stand today and how they may change in the future.

Three Key Areas Where Income and Transfer Taxes Mix

All too often, people tend to look at the two types of tax in isolation. We focus on minimizing income taxes during our lifetimes. Then when we turn to estate planning, we set our sights on strategies to minimize transfer taxes.

In reality, you need to view them in tandem and pay careful attention to the following:

  • The step up in income tax basis is a major tax benefit

Beneficiaries enjoy a step up in income tax basis on any assets they inherit upon your death, except for certain retirement accounts. This means any built-in capital gains are disregarded for tax purposes and the cost basis is reset to the current market value at death.

Assets gifted during your lifetime, however, don’t receive this step up. Capital gains taxes will be applied to gains based on your original purchase price. Therefore, a gift you make during your lifetime may not be as ideal for income tax purposes, even if you think it might save a lot in estate taxes when you die.

So, if you do gift assets during your lifetime, it’s important to consider the income tax basis of each asset. Let’s say you have two stock positions you want to gift to your children. Both are worth $1 million, but one has an income tax cost basis of $100,000 while the other has a basis of $850,000. Instead of gifting the former (and burdening your children with the capital gains tax that will be due on $900,000 of appreciation), you could gift them the latter and transfer the larger gain as part of your estate where they’ll receive a step up in basis.

  • Transferring assets also can transfer income generated by them

Often when you transfer assets to beneficiaries, you’re also transferring the income those assets generate. This can be beneficial from a tax standpoint because children and other family members may be in a lower tax bracket or live in a more tax friendly state. But not always.

Adult children in their peak earning years may be in the same or a higher tax bracket than their parents. Or your beneficiaries may live in a less tax-friendly location than you do. And gifts to a minor or full-time student under age 24 may trigger the ‘kiddie tax,’ which taxes the child’s unearned income at the parents’ rates.

  • Special income tax rules apply to trusts

Irrevocable trusts often play an essential role in the tax-efficient transfer of wealth between generations. It’s important, therefore, to understand that special income tax rules apply to trusts.

Trusts are generally set up as either “grantor” or “non-grantor” trusts:

Grantor Trusts. When you fund an irrevocable grantor trust, you are responsible for all income taxes on the trust property and the trust is largely disregarded for income tax purposes.

In many cases, the best tax result can come from gifting the assets through an irrevocable grantor trust. This allows you to transfer assets but keep the income tax burden yourself. While it may seem counter-intuitive, this approach can offer a lot of flexibility to maximize the overall tax results.

Non-Grantor Trusts. With a non-grantor trust, the trust is its own taxpayer and generally will incur income taxes at the highest rates (in 2022, a 37% federal tax rate on all ordinary income over $13,450 annually) unless income is distributed to the beneficiaries.

In that case, distributions can be used to shift income to the trust beneficiaries who may pay taxes at a lower rate. While making distributions to beneficiaries can save income taxes, you may not intend for your beneficiaries to receive regular payments from the trust.

With a non-grantor trust, it is also important to understand the state-level taxation of your trust. It can be possible to avoid state income tax on trust assets by locating the trust in a jurisdiction like Delaware. But you need to carefully consider the residences of all trustees, beneficiaries, settlors or testators, the sources of income and the place of administration of the trust. Depending on the states potentially involved, different rules may apply and can catch the unwary.

Five Helpful Tax Mitigation Guidelines
  1. Gift cash or high-basis assets. When you gift cash, there’s no income tax cost to your gift. The same holds true when gifting a high-basis asset such as a property you recently purchased. Since little to no capital gains are embedded in the asset, you avoid saddling the recipient with an unexpected tax liability. This is especially true when making smaller gifts where you have more options to choose what you what to give and what you want your beneficiaries to receive.
  2. Donate highly appreciated, low basis assets. When you give appreciated assets to charity, you avoid needing to recognize the gain for income tax purposes. You’re also generally able to take a tax deduction for the full value of the gift (subject to a 30% limit of your AGI for gifts to public charities). The charity receives the full value of the gift, since typically it can sell the asset without incurring any tax liability. This can involve appreciated stock, as well as assets like real estate, digital assets and certain artwork if the charity is willing to receive them and the gift is properly documented with receipts and appraisals. With bigger gains, more involved transfers are possible. In general, if you involve charity in your plans, your tax savings options multiply.
  3. Take advantage of your annual gift exclusion. In 2022, you’re allowed to gift up to $16,000 to as many individuals as you want, without counting against your gift and estate tax exemption and without the need even to file a gift tax return. While that amount may not seem like much, over time it can really add up. For a married couple with three adult children that’s $106,000 per year you can gift. Add in spouses and it climbs to $212,000 annually. And if each of those couples has two children of their own, the annual total rises to $424,000. Over the course of 20 years, that’s an additional $10 million of wealth you can transfer without ever eating into your lifetime exemption amount. You also can directly pay for their medical and tuition bills without impacting your exemption. And you can frontload up to 5 years of annual exclusions with gifts to a 529 College Savings Plan account.
  4. Run the numbers on whether to make larger gifts for estate tax purposes. Depending on your situation, making larger gifts that use your gift and estate tax exemption may be the best planning decision you can make, or the worst. There’s really no way to know until you run the numbers to balance the potential income tax costs of a large gift with the estate tax savings. Your financial plan should also ensure that gifting assets won’t adversely impact your own wealth picture. In addition, it’s important to consider how a gift might impact the beneficiary’s financial situation. The numbers may not yield a simple answer, but even then, they can help structure a gift to minimize negative impacts–for taxes, future cash flows and family dynamics.
  1. Focus on the more knowable shorter-term. Estate planning is a long-term consideration, so there will always be an element of uncertainty involved. Your financial circumstances could shift, or the tax rules could change. In this context, it’s always a good idea to focus on the shorter-term (i.e., the next five or so years) when evaluating the income, gift, and estate tax consequences of a proposed gift or other planning strategy.

While your plans may be designed for the long-term, if the numbers and other factors don’t make sense in the shorter term, you may be banking on more assumptions than you realize. In contrast, if the shorter-term impact is positive, there’s a good chance it will remain that way for the long term.

Perhaps more important than any strategies you may use, take as much time as you need to articulate your priorities. Being ultra-clear about your financial goals can help you navigate the tensions between income and transfer taxes and make decisions that help optimize your after-tax results.


This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.


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