Taking advantage of the stepped-up cost basis means family members pay less in taxes on appreciating stocks.
Say you’ve carefully invested in the stock market for years, and your portfolio is performing well. However, you’re aware that you won’t be around forever and want your family to benefit from your investments while paying as little tax as possible. How do you go about it?
Do you sell the stocks and gift the money to your heirs?
Should you gift the stocks to your family members?
Is it better to leave the stock to your beneficiaries in your will?
All options may be worth considering in different scenarios. However, there is a significant tax benefit associated with leaving the stock to your heirs when you pass away.
Here’s what you should know about stepped-up cost basis and how it can benefit your family.
Selling the stock and gifting the money
Perhaps the most straightforward way of passing investment wealth to beneficiaries is by selling the stock and gifting the money or leaving it to them when you pass away. With this method, heirs won’t have to worry about dealing with assets and can receive the cash directly or through a trust.
However, in this scenario, the stockholder is responsible for paying capital gains, state, and local taxes on the amount this stock appreciated over the years. For example, if you purchased 10,000 shares of a particular stock in 1985 for $2 per share, and it’s now worth $100 per share, you’ll have to pay taxes on the $980,000 appreciation of the asset when you sell it.
Capital gains, state, and local taxes all apply to this amount and, depending on location, can eat into earnings significantly. Selling the stock means the government will immediately take a big chunk of your profits.
Gifting the stock
Stockholders might consider gifting stock to their beneficiaries before passing away. This arrangement allows the shareholder to oversee the process and ensure that the assets end up in the right hands. A stockholder might consider this scenario if they want to teach their heirs about the market.
The problem with gifting a stock is that capital gains still apply at the same rates as selling the stock and gifting the money. Using the above example, the heirs would have to pay capital gains tax on the assets’ $980,000 appreciation. The tax isn’t due until the stock eventually sells, so the tax burden could end up being even more significant.
This scenario often isn’t ideal because you want to leave as much as possible for your family members when you’re gone. When gifting stock, the tax burden is notable and falls entirely on the beneficiaries. However, a different strategy can limit the amount of taxes your descendants will pay when inheriting your investments.
Leaving the stock as an inheritance
The drawback of leaving stocks as an inheritance is that your heirs won’t receive them until you die. Nevertheless, the tax benefits make a little patience extremely valuable. The main reason to leave stocks in a will is the stepped-up cost basis that limits the gains on which your successors pay tax.
In this scenario, capital gains don’t pertain to the stock’s value when you purchased it in, say, 1985. Instead, they apply to the stock price on the day you die because of the stepped-up cost basis.
So, even though you bought these stocks for $2, this rule completely wipes out these assets’ original cost basis. It’s similar to your heirs purchasing the assets on the day they inherit them for tax purposes.
If your family sells the stock the day after you die, they only have to pay capital gains tax on the amount the asset appreciates from the previous day (or write off the day’s loss). Stockholders with significant investments can achieve tremendous value because they could save hundreds of thousands of dollars in capital gains taxes.
Keep in mind that these stocks could trigger the estate tax, so you’ll want to be aware of those rules and how they can affect potential tax situations, too. It’s also worth noting that this step-up basis’s days could be numbered, as the new Biden administration seeks to eliminate it.
Although every situation is different, it often makes sense to take advantage of the stepped-up basis because it minimizes the amount of money for which capital gains are applicable while maximizing the asset’s value for family members.
The value of competent wealth management advice
Investments and wealth management aren’t always straightforward, so getting professional advice is often advisable. The more information an investor has on potential tax-saving methods, the easier it becomes to hold onto wealth and pass it down intact.