Step-Up in Basis Impact: Understanding Its Role in Estate Planning

Understanding the Step-Up in Basis and Your Estate

Estate planning can be complicated, especially when it comes to the “step-up in basis” rules. These rules play a big role in determining the after-tax value of your assets when you pass away. Here’s a plain English guide to how they work and what it means for your heirs.

What is Step-Up in Basis?

When you buy an asset like stocks or property, you have a “basis” – basically what you paid for it. If the asset increases in value and you sell it, you owe tax on the gain between your original basis and the sale price. However, when you die, the tax rules often “step up” the basis to the current market value. This eliminates the embedded gains, allowing your heirs to sell immediately without owing capital gains tax.

Joint Assets Only Get a Partial Step-Up

Many married couples hold assets jointly. But this can limit the step-up for the survivor. Say you bought stock for $100,000 that is now worth $300,000. In community property states, the step-up would be the full $300,000 when the first spouse dies. But in other states, only the deceased spouse’s half gets stepped up – so your basis would only increase by $150,000.

Strategic Planning Can Achieve a Full Step-Up

By shifting appreciated assets into accounts owned only by the spouse expected to die first, couples can obtain a full step-up. This takes coordination but can provide substantial tax savings. Even gifting certain assets can work.

High Federal Exemptions Persist

Despite calls for change, federal estate and gift tax exemptions remain very generous – $12 million per person. Effective planning can shield over $24 million for a married couple. While exemptions may drop in 2026, taxes likely won’t impact most heirs anytime soon.

The step-up in basis is an important piece of the estate planning puzzle. Strategic ownership and transfer of assets can minimize gains taxes for your heirs. With some guidance on the rules, your family can benefit from substantial savings.

Case Study:

The Thompsons and the Step-Up in Basis

Meet Charlie and Sabrina Thompson, a married couple living in Virginia, a separate property state. Over the years, they have accumulated significant assets, including a jointly owned taxable brokerage account with stocks valued at $500,000. This account mainly holds shares of Maple Inc. which they purchased for $200,000 ten years ago.

The Situation
Sadly, Charlie recently passed away. Since Virginia is a separate property state, Charlie and Sabrina each owned 50% of the Maple Inc shares purchased for $200,000. On the date Charlie died, his half of the Maple Inc. stock was valued at $250,000.

The Step-Up in Basis Impact
According to the step-up in basis rule, the basis of Charlie’s share of the Maple Inc. stock is “stepped up” to its market value on the date of his death – $250,000. This gets added to Sabrina’s original basis of $100,000 in her half of the shares.

The Outcome
After Charlie’s passing, Sabrina’s total basis in the Maple Inc. shares is now $350,000 ($250,000 from Charlie’s share + $100,000 of her original basis). If Sabrina were to sell the shares at their current market value of $500,000, she would only need to pay capital gains taxes on $150,000 ($500,000 – $350,000) versus the $300,000 if Charlie had not died.

Case Study:

The Martins and the Individual Ownership Step-Up in Basis

Meet Robert and Emily Martin, a married couple from Florida, each with assets owned individually. Robert solely owned a beachfront property purchased 20 years ago for $300,000. He held this in his personal revocable living trust. Emily separately owned a vintage car collection valued at $400,000 under her name.

The Situation
Unfortunately, Robert recently passed away. At the time of his death, his beachfront trust property had appreciated significantly to $1 million. Since this asset was owned by Robert’s trust, how would the step-up in basis rule apply?

The Impact
Because Robert held the beachfront property in his revocable trust, the full $1 million value becomes part of his estate at death. This qualifies the entire property for a complete step-up in basis to its date-of-death value of $1 million.

The Outcome
After Robert’s death, the trust property’s new basis is $1 million. If Emily sells it for $1 million, she would owe no capital gains taxes because the property’s basis equaled the sale price. However, Emily’s car collection stays in her name with no change. It would only receive a step-up in basis if she passes away.

For a personalized approach to navigating your estate planning journey, don’t hesitate to reach out for a consultation.
Disclaimer
The content on this site, provided by Able Wealth Management, is purely informational. While we aim for accuracy and completeness, we cannot guarantee the exactness of the information presented. The views and analyses expressed in this blog represent those of the authors at Able Wealth Management. They should not be considered as investment advice or endorsement of any particular financial instrument or strategy. Any references to specific securities and their performance are purely informational and should not be taken as advice to buy or sell.Before implementing any information or ideas presented, we strongly advise consulting with a financial advisor, accountant, or legal counsel. Investing carries inherent risks, including potential capital loss. Asset values can fluctuate over time and may be worth more or less than the original investment. Past performance does not guarantee future results, and Able Wealth Management cannot ensure that your financial goals will be achieved. Information from third-party sources has not been independently verified by Able Wealth Management. Although we trust these sources, we cannot assure their accuracy or completeness.

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Volatility Drag

Volatility drag, often unnoticed by many investors, plays a significant role in the performance of investment portfolios, especially in markets characterized by high volatility. Understanding volatility drag is crucial for making informed investment decisions and managing long-term investment performance.

Understanding Volatility Drag

Volatility drag refers to the negative effect of investment volatility on compound returns over time. It occurs because losses have a more significant impact on portfolio value than gains of the same magnitude. For example, if an investment loses 10% one year and gains 10% the next, the investment will not return to its starting value due to the mathematical asymmetry between gains and losses. This phenomenon underscores the importance of minimizing large fluctuations in investment value to protect long-term returns.

The Mathematics Behind Volatility Drag

The mathematical principle underlying volatility drag is relatively straightforward but profound in its implications for investors. The key concept is that percentage gains and losses are not symmetrical. A 50% loss requires a 100% gain to break even, not a 50% gain. This asymmetry means that volatility (up and down movements in price) can erode the compound growth rate of an investment, even if the arithmetic mean of the returns seems healthy.

Example of Volatility Drag

Consider an investment with the following annual returns: +20%, -15%, +10%, and -5%. While the arithmetic mean of these returns might suggest a modest positive performance, the compound annual growth rate (CAGR) would tell a different story, factoring in the volatility drag and showing a lower effective return than the arithmetic mean would suggest.

Implications for Investors

  • Risk Management: Understanding volatility drag emphasizes the importance of risk management strategies, such as diversification and the use of derivatives for hedging, to minimize significant downturns in portfolio value.
  • Investment Strategy: Investors might consider investment strategies that aim for steady, consistent returns over those with potentially higher but more volatile returns. Such strategies might include investing in low-volatility stocks, index funds, or using dollar-cost averaging to mitigate the impact of market fluctuations.
  • Psychological Aspects: Volatility drag also highlights the psychological challenge for investors who may overreact to short-term market movements. A long-term perspective is crucial for successful investing, as frequent trading in response to volatility can exacerbate the drag on returns.
  • Performance Evaluation: When assessing investment performance, considering both the arithmetic mean return and the compound annual growth rate (CAGR) can provide a more comprehensive view of an investment’s performance, factoring in the effect of volatility.

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