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Sustainable Investing

Don't Fret About Tax-Law Changes--Yet

How changes to the step-up in cost basis could affect your financial plan.

A higher capital gains tax, as has been proposed by the Biden administration, would have a meaningful impact on just a small subset of investors during their lifetimes.

But proposed limitations to the “step-up” in cost basis on inherited assets have the potential to affect the estates of a broader swath of individuals.

Of course, both changes are bound to be contentious and will have to make it through a deeply divided congress before becoming law. The Biden proposal is an opening salvo; there could well be significant alterations along the way.

That said, investors with sizable taxable accounts will want to give some thought to whether and how changes to the step-up rules might affect their plans. For example, a reduction in the step-up would make lifetime giving more attractive; the case for leaving appreciated assets behind in taxable accounts would be diminished. In addition, the proposed limits on the step-up are a wake-up call to continue to maintain cost-basis records for assets purchased in taxable accounts (nonretirement accounts) before 2010.

A Review of the Step-Up

Under current tax law, the cost basis of inherited assets is whatever the price of the asset was on the decedent’s date of death. (An alternate valuation date--six months after the date of death--is also available if that would be more advantageous.)

To use an example, let’s say your mother purchased 100 shares of a stock for $2,000 ($20/share) in the 1980s and it was worth $12,000 ($120/share) on the date of her death. If she held the position in a taxable/nonretirement account and you inherited the stock from her, your cost basis would be $12,000; the value of the shares would “step up” to their current level. In other words, the entire $10,000 of her gains wouldn’t be subject to taxes. If you were to sell shortly after inheriting and the share price were $125, you’d owe taxes on just the $500 difference between your stepped-up cost basis of $12,000 and your $12,500 sale price.

That's an incredibly generous provision from a tax standpoint. In addition, it saves heirs from a major recordkeeping headache. They need only know the asset's value upon date of death, not its purchase price, whether the stock was purchased in multiple installments or all at once, or whether she reinvested dividends or capital gains. The proposed rules would remain the same for people who die with gains of less than $1 million in taxable holdings ($2 million for married couples). That means that married couples could effectively pass $2 million in tax-free gains to their heirs.

What Could Change and Who It Might (and Might Not) Affect

Gains in excess of that threshold, however, are a different story. Under the proposal, the step-up wouldn't apply to gains of more than $1 million. Instead, the inheritor of those assets would also inherit the decedent's cost basis, and such gains would be subject to the highest capital gains rate. That’s currently 20% but would nearly double, to 39.6%, under the Biden plan. (The tax rate would jump to 43.4%, factoring in the Medicare surtax.) Estates in excess of the current estate-tax-exemption amount--$11.7 million for individuals and $23.4 million for couples--could be subject to the higher tax rate as well as estate tax.

The elimination of the step-up would go hand in hand with the higher capital gains rate. After all, if the capital gains rate were increased but the step-up were left in place for all taxpayers, wealthy individuals would aim to reduce sales of stock during their lifetimes, knowing that the appreciation on those assets would escape taxation after their death.

A fairly small subset of investors would be affected by proposed limits to the step-up. In 2020, before the current proposal, research from the Tax Foundation showed that a complete repeal of the step-up would primarily affect the top 1% of earners; the proposed $1 million exemption further limits the impact of the new step-up proposal for most taxpayers. After all, most investors hold their assets in retirement accounts; unlike taxable/non-retirement accounts, they're unaffected by changes to either capital gains tax rates or limitations in step-up. To the extent that investors do have assets in nonretirement accounts, their investment gains are unlikely to exceed the $1 million threshold. Their investments will pass tax-free or nearly tax-free to their heirs, just as they always did. Moreover, family farms and businesses would escape taxes if given to heirs who continue to run those businesses.

Yet as I noted earlier, proposed limits on the step-up have the potential to affect more people than would be affected by a higher capital gains rate during their lifetimes. In order to be subject to the proposed higher capital gains rate on assets you sell during your lifetime, you would need to tick two boxes: You’d need to have capital gains, and you'd also need to have income of more than $1 million a year. And you could potentially dodge the higher tax by selling appreciated assets in years in which your income came in below that $1 million threshold.

Meanwhile, the limits on the step-up could potentially affect people who didn’t necessarily have high incomes but who managed to save a lot in taxable accounts during their lifetimes or inherited assets, which is a potentially larger share of the population.

Planning Implications

The step-up in cost basis that is currently allowed is an extraordinarily generous provision in the tax code. Research from the Joint Committee on Taxation put the forgone tax revenues associated with the step-up between 2018 and 2022 at more than $200 billion. In this case, the government's loss is heirs' gain. Other tax-saving strategies can't fully replace the tax savings that wealthy families enjoy by fully skirting the taxes on investment gains after death.

Limitations on the step-up would make giving appreciated assets to loved ones during your lifetime more attractive, in that you would no longer have such a strong tax incentive to pass those assets after your death. You would also be able to enjoy helping your loved ones, a benefit that can’t readily be quantified.

In addition, a proposed higher capital gains rate and limitations on the step-up are a wake-up call to take a closer look at highly concentrated positions in your portfolio, which become more commonplace after a long winning streak in the market. While selling them during your lifetime may cost you in taxes, doing so also has the potential to reduce your portfolio’s risk level.

In addition, changes to the step-up and capital gains tax rate embellishes the case for fully funding retirement accounts before turning to taxable accounts. As noted above, retirement accounts are unaffected by these changes. (Of course, for very high-income investors, fully funding retirement accounts and other tax-sheltered accounts like health savings accounts and 529s is a drop in the bucket relative to what they can save and invest.)

Charitable giving of highly appreciated assets is also a way to tax-efficiently divest of assets that have the potential to be subject to higher taxes down the line. Donor-advised funds can be effective in this context, as can more-sophisticated strategies like charitable remainder trusts.

Finally, proposed limitations on the step-up underscore the importance of maintaining scrupulous cost-basis records, especially for taxable accounts. While investment providers began to report cost-basis information directly to the IRS in 2010, the onus is on investors to maintain records for assets purchased before that time. If you hold such assets in your portfolio, use the step-up proposal as an impetus to check up on your records and make sure they're readily accessible to your loved ones.

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