Inheriting assets tax-free by using upstream gifting strategies

If you’re a long-term buy and hold investor (eg low cost S&P 500 index funds, long-term primary residential or rental properties, etc) you can accomplish very similar goals to a Roth IRA by using strategic gifting strategies with elderly parents. However, before we get into how to do this, we need to understand the value of both a Roth IRA and the step-up in basis provision.

A Roth IRA is one of the best financial planning tools available. A Roth IRA allows an individual to contribute after-tax funds to an account that will grow tax-free for the life of the individual—and pass on tax-free at death. However, there are some key limitations here:

1. Contribution amounts are limited each year (for 2023 it’s currently $6,500 if you’re below age 50 and $7,500 if you’re 50 and older.)
2. Can’t contribute at all if income is above limits (for 2023 it’s $144,000 for single filers and $214,000 for married filers). If your income is above this, in order to contribute to a Roth IRA you have to use the Backdoor Roth strategy and are still limited in the amount of contributions as previously described.
3. Have to wait until age 59.5 to withdraw income without penalty for a traditional IRA. For a Roth IRA you can withdraw the principal (but not the gains) at any time.

However, buy-and-hold investors can accomplish these same goals simply by using gifting strategies with elderly parents. This allows high earning clients who don’t qualify for Roth IRAs the ability to invest significantly higher amounts and the ability to gain access to these funds much sooner.

Step-up in basis

Before we can get into the details of this topic, we need to cover an important topic when it comes to inheriting assets tax-free: step-up in basis. Step-up in basis is a provision that allows families to pass on their wealth tax-free to their heirs at death provided that the total wealth at the time is below the estate exemption limits at the time (currently this is at $25.8 million in 2023 for a married couple, but will be decreasing to about $12M per married couple in 2026).

What this means is that if elderly parents want to pass on wealth to their kids, it is better for them to let their assets grow until death and then pass those assets tax-free to their kids instead of selling those assets, paying taxes, and then giving what’s left over to the kids.

Let’s look at an example.

Example 1:

John and Sally are both 60 years old living in California. They have a portfolio of stocks that is currently worth $1M, but the amount they’ve invested to get that $1M portfolio is only $700,000. This means there is an unrealized gain of $300,000. If they were to sell this asset today, they would owe taxes on the $300,000 gain. However, they decide not to sell their portfolio. They decide to keep it for 30 years and continue investing in the stock market.

Let’s assume they make 8% compounded every year on their investment. $1M compounded for 30 years at 8% is $10,062,657 ($1,000,000 * 1.08^30 = $10,062,657). At the end of 30 years, they decide to sell the portfolio and give the proceeds to their kids. Since their basis in the policy is only $700,000, this means that John and Sally will have to pay taxes on the gains. The gain on the investment is the difference between the current market value of the portfolio ($10,062,657) and the basis ($700,000). This is a taxable gain of $9,362,657. This puts them at a total effective tax rate of 36% (23.1% federal capital gains and net investment income tax and 12.9% California state income tax). This amounts to a tax bill owed of $3,374,943. After tax, that leaves John and Sally with only $6,625,057 to give to their beneficiaries.

Now let’s assume that instead of selling their portfolio after 30 years, they invest for 30 years and pass away and then their heirs inherit the assets. In this case, the portfolio value of the investments is still $10,062,657, but the basis is no longer $700,000. Since the assets were passed on to the beneficiaries through death the basis in the assets gets “stepped up” from $700,000 to the current market value of the portfolio at the time of death (i.e. $10,062,657). This means that there is no taxable gain at the time of death. John and Sally’s heirs can then sell the portfolio at that time and keep the entire $10,062,657 to themselves.

By utilizing the step-up in basis provision and passing on assets through death instead of selling them, John and Sally are able to pass on $3.4 million dollars more to their heirs.

The value of passing on assets using step-up in basis

Using upstream gifting strategies to elderly parents to pass on tax-free wealth

The above example showed how John and Sally can pass on tax-free wealth to their kids by using step-up in basis. However, kids of elderly parents can use gifting strategies in combination with step-up in basis to grow tax-free wealth as well. This strategy is known as “upstream gifting”.

Current tax law allows each person to gift $17,000 each year to as many people as that person wants without any tax implications. If a person wants to give additional amounts above this $17,000 to a person, it is possible to still do this without any tax implications as long as the total gifts given by that person above the $17,000 annual amount does not exceed the estate exemption limit (currently $25.8 million per married couple as mentioned above). 

Let’s look at an example.

Example 2:

Mark and Kathy are both 40, living in California, and are long-term buy and hold investors. They have $68,000 that they want to invest each year until retirement in Vanguard’s low cost S&P 500 growth index fund (VUG). They are debating investing that amount each year in VUG via their own taxable account or gifting the money each year to Kathy’s parents, Nancy and Steve who are both 70 and having them invest it in VUG so that they can inherit the assets later from her tax-free using step-up in basis. Mark and Kathy would each use the gift exclusion amount of $17,000 to give to each of her parents. Mark would give $17,000 to Nancy and then another $17,000 to Steve. Kathy would then do the same. The total amount gifted to Kathy’s parent’s each year would be $68,000.

Let’s assume that Nancy and Steve live another 15 years to age 85. How much value is created by Mark and Kathy gifting assets each year and inheriting the money tax-free when Nancy and Steve die versus just investing the assets for themselves and selling at the end of 15 years?

As the table below shows, by Mark and Kathy choosing to each use their gift exclusion amounts to give a total of $68,000 to Kathy’s parents and then inheriting the assets when Kathy’s parents die, Mark and Kathy can save over $300,000 in taxes.

Combining annual gifting strategies with step-up in basis

There are numerous ways to enhance this strategy. One is that Mark and Kathy can give multiple gifts of $17,000 to each of their siblings and ask those siblings to give it to Kathy’s parents on their behalf. This increases the amount of essentially tax-free contributions that Mark and Kathy can make.

Another important enhancement is to focus on an investment strategy for the gifted assets that is focused on long-term growth as opposed to a strategy that is focused on yield. This is because those that focus on growth will allow for more unrealized gain than those that are distributing yield. Distributing yield will also be taxable to Kathy’s parents.

Furthermore, Mark and Kathy should be focused on using this strategy to invest in assets that they want to hold for the long-term (e.g. low cost S&P 500 Index, rental property, etc) as opposed to short-term assets they want to sell quickly. Only assets that are held for the long-term will benefit from this strategy.

Another enhancement to this strategy is to gift assets that have appreciated a lot and have a low basis instead of gifting cash. This allows for the potential to eliminate taxes on the unrealized gains. This works for both real estate and investment portfolios. We’ll start with the real estate example first since that’s the easiest to understand.

Example 3:

Mark and Kathy have a rental house in California that they bought for $300,000 fifteen years ago that now is worth $1,000,000. Let’s assume they want to keep the house for another 25 years until they retire and then sell it. Let’s assume that in 25 years the house is worth $2,000,000. If they were to sell it at that point, the unrealized gain would be $1.7 million. Since Mark and Kathy live in California, they have to pay federal taxes and California state taxes on the gain. The total taxes here paid would be $577,547 or about 34% of the gain.

However, if Mark and Kathy gift this property to Kathy’s parents and inherit it when they die—for the sake of this example we’ll assume it’s in 25 years—Mark and Kathy will get to keep all of the gain tax-free. This includes the $700,000 of unrealized gain before they gave the house to Kathy’s parents as well as the $1,000,000 worth of unrealized gain after they gave the house to Kathy’s parents. While gifting a large asset like a house will reduce the value of Mark and Kathy’s gift exemption by the value of the house, if Kathy and Mark don’t expect the value of their estate to ever hit the gift exemption limits ($25.8 million in 2023), then this gift to Kathy’s parents won’t affect their ability to give gifts to others in the future (for example, their own kids when they die).

The value of gifting appreciated assets to parents and inheriting it tax-free

This same concept applies to gifting a portfolio of investments that has a large unrealized gain as well. If Mark and Kathy have an investment portfolio with a lot of unrealized gains, they can gift her parents the portfolio. That way the portfolio will continue to grow without paying taxes on the gains and Mark and Kathy can inherit the appreciation on the portfolio tax-free when Kathy’s parents pass away.

If Mark and Kathy need the funds prior to the death of Kathy’s parents, Kathy’s parents can sell some of the assets and gift the proceeds back to Mark and Kathy. While this will incur taxes on the sale, there should be some savings here given that Kathy’s parents are retired and in a lower tax bracket than Mark and Kathy who are working in their prime earning years. Better yet, Kathy’s parents can borrow against the portfolio using margin lending/securities borrowing so that that the assets can continue to grow tax-free. An added bonus here is that all the interest here is fully tax-deductible—unlike mortgage interest payments where the deduction is capped.

There are cons to this strategy, however. The biggest one is that once Mark and Kathy gift the cash or portfolio to Kathy’s parents, they lose control of the assets. Those assets now belong to Kathy’s parents and they can do whatever they want with the assets. If Kathy’s parents get into an argument with Mark and Kathy, her parents are fully free to change the beneficiary on the portfolio to someone else besides Mark and Kathy. However, there are even steps to protect against this.

If Kathy’s parents set up a revocable trust with Mark and Kathy being the beneficiaries as well as the trustees of the trust, then these risks can be mitigated. Instead of gifting assets directly to Kathy’s parents, Mark and Kathy can gift the assets directly to the trust—of which Mark and Kathy are both the trustees and the beneficiaries.

Note that it’s important that the trust be a revocable trust and not an irrevocable trust. A revocable allows you to utilize the step-up in basis provision while an irrevocable one does not.

Conclusion

A Roth IRA is often seen as the holy grail of retirement accounts. Unfortunately, clients in high tax-brackets are not able to avail themselves of Roth IRAs. By using gifting strategies in place of contributing to a Roth IRA, high net worth clients can essentially replicate the benefits of a Roth IRA with larger contribution amounts and earlier withdrawal privileges.

Furthermore, if clients elderly parents have assets that they are thinking of selling (eg like a home or rental properties), the parents and their children should evaluate if it might be economically better to hold the assets until death so that their children can inherit the assets tax-free. If the parents need liquidity, they can either borrow from their portfolio—or from their children.