Leaving Assets to Your Heirs: Could You Benefit From a Step Up in Basis?

Does it make more sense to pull money out of your Roth IRA or your brokerage account for income in retirement? Depending on your situation, you may want to hold on to your taxable investments for the potential future step up in basis.

If you have a brokerage account, you’re probably familiar with the concept of cost basis (the original price you paid for an investment). But when you pass away, an investment’s cost basis changes—it, instead, assumes the investment’s value at the date of your death. This is known as a “step up in basis,” and it effectively makes gains during the original owner’s lifetime tax-free for his or her heirs.¹

For example, suppose you bought a stock for $20 per share, and now it’s worth $100 per share. If you sell it, you will have a taxable capital gain of $80 per share. However, if it’s worth $100 at the date of your death, your heirs will only be taxed on any appreciation above $100 when they sell it. This applies exclusively to investments in taxable accounts, as opposed to tax-advantaged accounts like IRAs, Roth IRAs, and 401(k) plans.

This tax rule can be a major benefit for families with wealth beyond what they will need for personal spending in retirement. The challenge for an investor (or financial advisor) is deciding whether to hold specific investments in anticipation of a step up. If you also have assets in Roth or tax-deferred accounts, you will want to develop a strategy to determine which accounts to spend down and which to preserve.

Let’s take the case where you’re deciding whether to fund your retirement spending with qualified tax-free Roth account distributions² or by selling stock (or stock fund) investments in a taxable account. For now, we’ll assume your investments are similar in the two accounts. (We’re aware that this is a big assumption.) There are four major factors to consider, in the table below:

Hopefully, the first three factors listed don’t need much additional explanation: If you have a big, unrealized gain in your taxable investment, as well as a high tax rate, and you don’t expect to live long, holding on to that investment can benefit your heirs significantly. The dividend factor, however, isn’t as intuitive. Dividends matter because they are taxed every year. Compared with a stock with no dividend, a dividend-paying stock (with the same total return) incurs taxes sooner, and its value grows more slowly. The impact of this tax drag builds over the years, so it’s particularly meaningful for someone with a long life expectancy. Interestingly, if the stock pays no dividend, life expectancy doesn’t matter because there’s no annual tax drag.

That’s a lot to consider, and these factors may not align the same way in your situation. Fortunately, we can use break-even cost basis percentage graphs to help with this decision.

Consider three examples in reference to the following charts. First, calculate your taxable investment cost basis percentage. To do that, divide the cost basis—usually available on your account statement—by the current value. Then, check it against the charts below. If your cost basis percentage is above the lines, it’s better to sell the taxable investment than to liquidate assets in a Roth account.

Example 1: Suppose you have a stock investment worth $10,000 with a $9,000 cost basis (90% of the value). And we’ll assume you will face capital gains taxes (at least 15%) on any gains you realize in your lifetime. Looking at Figure 2, 90% is above the break-even lines for both the 15% and the 20% capital gains tax rates. That means if you need money for expenses, you should sell that taxable investment and hold on to any Roth accounts. That works out better long term (after taxes) for your heirs.

Example 2: Now suppose the investment has a $4,000 cost basis (40%) and pays a 2% annual dividend. If you’re 55 and think you’ll live another 30 years, that 40% cost basis is above the lines in Figure 3. So you’d still want to sell the investment instead of taking a Roth distribution. Note that the break-even lines for a dividend rate below 2% would be higher on the graph—closer to the straight line in the “no dividend” graph in Figure 2.

Example 3: But if you’re 85 and figure your life expectancy is under 10 years, that moves your 40% cost basis to the right and below the lines in Figure 3. That means, it makes sense to hold on to the investment for the step up and use your Roth account to fund your expenses instead.

As you put this into practice, consider a few additional details when determining whether to sell appreciated assets over Roth account investments:

Having assets you can leave your loved ones is a good problem to have. Proper planning can help ensure that those assets are as tax-efficient as possible.