With the most recent submission of a tax plan from President Joe Biden, a proposal to eliminate the “step-up in basis” has been introduced for discussion. Of all the proposed tax code changes, this is one we find to be the most impactful for families and individuals as they consider their estate plan and gifting strategies in the years ahead. The elimination of this provision would change the way we approach retirement income strategies and legacy planning. It will change how we strategies "which assets to spend first" in retirement and "which assets to leave behind" to our heirs.
What Is A Step-Up In Basis?
Simply put, a step-up in basis is a tax provision (or loophole) that allows a recipient of inherited assets to reduce the capital gains owed on these assets by revaluing them at the time of inheritance. Essentially, all the gains an owner may have in an investment are no longer taxed once the owner of that investment passes away and the shares are inherited by his or her beneficiary.
For example, let’s assume Mary purchased 100 shares of stock in XYZ company for $100 per share. This is a $10,000 investment. Assume Mary held this stock and watched it’s value grow to $300 per share during her lifetime. If she were to sell all the shares of XYZ company, she would typically owe tax on a capital gain of $200/share ($300 value - $100 initial investment).
If Mary were to pass away, however, before selling her shares of XYZ stock, the tax situation changes. Mary’s son, Brian, would receive a “step-up in basis” on the inherited shares of XYZ stock. The new basis would be $300/share, and he could sell all his shares on the day of receipt without any capital gains tax being owed on that transaction.
What is Being Proposed?
President Joe Biden’s administration has proposed eliminating this “step-up in basis” loophole entirely. While the example above relates to shares of stock, this elimination would also apply to the inherited value of real estate, business ownership, bonds, and other capital assets that stand to be inherited upon death of an owner.
This is a VERY big change in the current tax code as it essentially will force millions of people to rethink their retirement income and legacy planning strategies. A lot of families have likely held onto assets with substantial gains in hopes of taking advantage of this loophole. A decision to pull retirement income from qualified retirement accounts has probably been made to avoid selling other non-qualified assets with embedded capital gains.
If this passes, strategies should change quickly.
What Steps Should We Consider If Step-Up In Basis Provision Is Eliminated?
If the step-up in basis provision is eliminated as many expect, then it is time to revisit retirement income and legacy planning strategies in your financial plan. Decisions on which assets should be held, spent, and who should realize the capital gains of existing assets become more important.
Let’s reference the earlier example. Mary owns XYZ stock worth $30,000. She could sell the stock and realize a $20,000 capital gain, or she could pass away and let her son, Brian, inherit the stock with the embedded capital gain. Assume Mary is retired and living off social security and a small pension. Her reported earned income is just $40,000/year. Brian is in his mid career and is a partner in a medical practice. His annual income exceeds $400,000. Mary could potentially sell shares of XYZ stock during her lifetime and only realize long-term capital gains at rates of 0% (if her adjusted gross income falls below $40,000/year) or 15% on the $20,000 gains. If she let’s Brian inherit those gains, then he stands to sell those shares and may be subject to capital gains at a rate of 23.8% or more (considering state taxes and any potential future capital gains tax rate increases).
In this case, Mary should work closely with her financial advisor and tax advisor to realize the gains before she passes away.
What About Retirement Income Planning?
The important term is withdrawal sequence. Withdrawal sequence is the order in which a retiree spends his or her assets in retirement. IRA money, for instance, is tax-deferred. Spending that money will count as taxable income. Roth IRA money is tax free. Taxable money is the money that typically contains embedded capital gains that must be dealt with on an annual basis if the investments are liquidated.
Some retirees are likely holding onto taxable assets with high embedded capital gains. They are hoping to receive a step-up in basis of these assets at their death. With the elimination of this provision, these retirees should consider liquidating some of these assets during their own lifetime to limit the capital gains tax and structure their eventual inheritance in a different manner.
Is There Anything We Should Do Right Now?
We aren’t really recommending any action at this time because tax proposals have a way of changing to gain bipartisan support before they are written into law. We recommend tracking the changes as they unfold and going ahead and bringing up the planning considerations that may affect you and your family with your financial planner or tax advisor. Start thinking about your own strategy and what those changes might look like for you. How might you take advantage of the years a loved one is still living to maximize the value of his or her estate? How might you realize the gains in your OWN accounts so as to maximize the benefits to your loved ones once you pass away? These are the types of questions you'll need to address if (once) this is written into law.
As always, if you need any help navigating these in your own financial plan, we would love to have a conversation about partnering with you so we can add value as these changes become reality! Schedule some time for us to connect and let’s be proactive with your financial planning together.