Planning Your Financial Future One “Step Up” At a Time

August 1, 2019  |  

Planning Your Financial Future One “Step Up” At a Time

Key Takeaways

  • Stepping up the cost basis of your assets can be a good planning tool when determining what assets to sell in your lifetime.
  • If possible, consider passing taxable assets with large unrealized gains to your heirs.
  • Assets that receive no step up include those held in any retirement accounts or annuities

An investor whose portfolio is grounded in the evidence based principles should expect their portfolio to grow over time, relative to the risk they are taking. Investment success, however, is not the only factor a person needs to consider when planning for the future. Investment returns are only the first step of the process. The next step is using tax strategies to minimizes how much you are paying in tax on your gains. What assets should you pass on to your children or other loved ones? How can you make sure that your financial success is not diminished after the government visits you every April? The answer to these questions is tax planning, and the “step up in basis” rules could be a significant opportunity.

In order to understand what a “step-up” refers to, one must first grasp the concept of capital gains. When making an investment outside of a retirement account (which are tax protected), a person purchases a security for a specific price. This price is called the “cost basis” of the investment. Capital gains are calculated using the difference between the cost basis and what the asset sells for. When the cost basis is less than the current value of the asset, this is called an unrealized gain. When the asset is sold, the investor will be subject to what is called a capital gains tax. On the other hand, if a person passes their asset to their heirs when they die instead of selling it, then his or her cost basis will be “stepped up” to equal the current value of the asset.

Here is a simple example of stepping up a cost basis

John purchased a $50,000 Mutual Fund in 2012 and then sold that fund for $250,000 in 2017. John was forced to pay capital gains tax on his gain of $200,000. John’s friend Kelly purchased the same fund in 2012, but she chose to hold the asset in order to pass it down to her daughter Mary after she passed away. When Kelly passed away in 2020, the mutual fund from 2012 was now worth $300,000. After Kelly died the cost basis was “stepped up” to equal the current value of the asset: $300,000. Now Mary owed no money in capital gains tax because of the step up which wiped away the previous unrealized gain, which allowed Kelly to leave her daughter Mary with her $300,000 asset with NO capital gains tax.

How to apply this information

This process of stepping up the cost basis of certain assets can be used as an ideal tool to plan out the distribution of your future assets. The strategy can be used with any capital asset that an investor owns including marketable securities, real estate, etc. Keep in mind that retirement accounts and annuities do not receive a step up because of their tax structure. At Independence Advisors we have always emphasized the importance of tax and investment planning. While receiving positive returns is great, one must always prepare and plan for the future. The “step up” method is just one of the strategies we can help you use to do just that.

Adviser is not licensed to provide and does not provide legal or accounting advice to clients.  Advice of qualified counsel or accountant should be sought to address any specific situation requiring assistance from such licensed individuals.

About Charlie Boinske, Intern - Summer 2017

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