Taxes on Generational Wealth Just Changed: Here’s What You Should Know

3 generation Family at home.
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When trying to figure out how to balance finances in retirement and setting up an inheritance for relatives, many people rely on irrevocable trusts to minimize the tax bill. Taxes are one of the most complicated financial topics out there. Tax professionals will do their best to stay informed of the rules and regulations.

However, there are still many grey areas and complexities when it comes to taxes and estate planning. On that note, the IRS recently changed the rules on your children’s inheritance — here’s a look at what this means for your estate planning.

What’s the New Guidance for Taxes on Irrevocable Trusts?

When passing down generational wealth, you likely want to ensure that your children get access to your assets while minimizing the amount of money that they have to spend on taxes. Until this year, there was some uncertainty about the assets held in an irrevocable trust and capital gains taxes. The purchaser does not hold the assets in an irrevocable trust, nor have they been distributed to the beneficiaries. Up until March of this year, the transfer from the trust at the time of the passing of the individual have received the step-up in basis.

In March of this year, the IRS issued Revenue Ruling 2023-2, which has a significant impact on estate planning moving forward. The new ruling states that property held in an irrevocable trust, not included in the taxable estate at death, will not receive a step-up in basis anymore. So at this first look, you’re subjecting your children to capital gains taxes with irrevocable trust planning under this new ruling. 

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Why Is This New Guidance Critical? 

Before, it wasn’t certain if assets passed down to beneficiaries with an irrevocable trust would get a step-up in basis, cutting out any capital gains taxes. This is essential because the tax bill could be hefty, and it would provide families with challenges if they don’t have the funds for such an expense.

When it comes to estate planning, many people with a substantial amount of assets would set up an irrevocable trust so that the assets would be taken away from the possession of the grantor. The assets that were placed under the control of the trust would then be passed down to the beneficiaries tax-free.

At the time the beneficiaries received the assets, they would come with a stepped-up value. This means that the assets are given the fair market value at the time of the grantor’s passing instead of at the time of purchase. Beneficiaries enjoyed the benefit of avoiding capital gains taxes on the assets until they were sold later on.

Aside from estate planning, many people used these trusts to qualify for Medicaid. The reason for this is that Medicaid requires people that want assistance for long-term care to spend down their assets before they can qualify. There aren’t many families that can afford such expenses out of pocket, so they depend on Medicaid. An irrevocable trust is one of the only tools to protect your assets from the spend-down process.

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How Can You Avoid Capital Gains Tax?

Although irrevocable trusts may not offer the same low tax bill after the new rule, there are still other ways to avoid capital gains taxes on your children’s inheritance.

The tool that you decide to use to reduce the inheritance taxes your children will be subjected to will depend on various factors, from the amount of assets that you possess to the state that you live in. It’s important that you explore all of your options before making a decision that could cost thousands of dollars.

Gifting Your Assets During Your Lifetime

According to Schwab, you can currently gift an unlimited amount of people up to $17,000 annually. If the figure is under this amount, the recipient doesn’t have to report it on their taxes.

It’s worth noting that you can give away more money than ever before at this very moment in time. Until Dec. 31, 2025, an individual can give away up to $12.92 million. Starting in 2026, the exemption will decrease to $5.49 million. If you don’t want to subject your children to a hefty inheritance tax bill, you can start giving away your money while you’re still alive in the form of a gift.

Life Insurance Policy

One of the best options for passing assets safely to your children without paying hefty taxes will likely be a life insurance policy due to this new guidance. You would have to consult with an experienced advisor regarding your life insurance policy options, but for most people, this will be the most practical option. You can try to take out a life insurance policy for the amount of money that you want to pass on to your children, since life insurance policies will not require any taxes.

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Closing Thoughts

If you have an irrevocable trust or want to learn more about estate planning, it’s a good idea to seek out an attorney who is knowledgeable in this subject matter. You should also involve your tax professional in this conversation, because you don’t want to set up your irrevocable trust incorrectly.

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