The step-up in basis is related to the capital gains tax, and we will look at this tax and a potential change to it in this post. But before we do, we will provide a quick overview of the way taxes can impact postmortem asset transfers.
State and Federal Income Taxes
Since the tax man always wants a piece of the pie, you may assume that an inheritance would be looked upon as taxable income by the IRS and state authorities. In a rare instance of good news that applies to taxation, this is not the case.
You do not have to report an inheritance when you file your tax returns, and this would include life insurance proceeds along with direct inheritances.
Individual Retirement Accounts
If you have a traditional individual retirement account, you make pre-tax contributions. When you take money out of the account, the distributions would be taxable, and the same thing is true for beneficiaries.
Roth accounts are funded with after-tax earnings, so if you choose to take withdrawals while you are living, they would not be taxed, and distributions to a beneficiary are not taxable either.
Estate and Inheritance Taxes
The federal estate tax is only a factor for people that are leaving estates that are valued at more than $11.58 million. This figure is called the credit or exclusion. We have a state-level estate tax in Connecticut, and is applicable on estates that exceed $5.1 million in value.
Estate taxes are applied to the portion of an estate that exceeds the amount of the exclusion. An inheritance tax can potentially be levied on distributions to each individual inheritor that is not exempt.
There is no federal inheritance tax, and there are six states with state-level inheritance taxes. Fortunately, Connecticut is not one of them.
Capital Gains Tax and the Step-Up in Basis
Now we can get to the main point of this post. The capital gains tax is applicable when a gain is realized. “Realizing a gain” is the act of selling the appreciated asset.
If you are leaving appreciated assets to an inheritor, the recipient would get a step-up in basis. From a capital gains perspective, they would not be responsible for the gains that accumulated during your life.
They would be responsible for gains that accumulate after the time of acquisition.
Possible Elimination of Step-Up in Basis
Very wealthy people routinely use the step-up in basis to their advantage when they are devising estate plans. Democratic presidential candidate Joe Biden’s platform includes an elimination of the step-up in basis. A reduction in the federal estate tax exclusion would also be a possibility. The current $11.86 million exclusion expires at the end of 2025, and new tax legislation could be enacted at any time.
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