This Tax Loophole Can Save Your Heirs Big. Here’s How T. Rowe Price Says to Use It

Deciding which accounts you’ll withdraw money from – and when you’ll take it – is an important decision in retirement. However, you may want to consider preserving assets held in a taxable brokerage account and passing them down to heirs.

That’s because taxable investments benefit from a step-up in basis, which is a tax loophole that resets the cost basis of an investment to its current market value when the original owner dies. As a result, whatever gains the investment made during your lifetime become tax-free. The taxes your heirs eventually pay will only be based on the investment’s value when they inherit it.

Need help deciding which accounts to make withdrawals from in retirement? Consider talking to a financial advisor.

Those with considerable wealth spread across both Roth and taxable accounts will have to determine which assets to tap to cover their retirement income needs, and which they’d rather bequeath to heirs. Luckily, T. Rowe Price recently took a closer look at the topic and developed break-even points to help you figure out whether you should preserve taxable assets or spend them.

Taxable vs. Roth Assets

Taxable accounts and Roth IRAs both play significant roles in the retirement and estate planning processes.

Roth IRAs are funded with after-tax dollars, so money can be withdrawn tax-free. Unlike a traditional IRA, Roth accounts aren’t subject to required minimum distributions (RMDs), making them attractive from an estate planning perspective. Then again, retirement accounts don’t benefit from the step-up in basis.

Taxable accounts, on the other hand, are subject to capital gains taxes. When you sell a stock or mutual fund inside a taxable account, your investment gains will be taxed at either 0%, 15% or 20% based on your income.

If you’re deciding between selling either Roth assets or taxable investments to meet your retirement income needs, you’ll want to consider your future step-up in basis. T. Rowe Price says there are four factors that can help you determine whether preserving taxable assets – and your step-up in basis – makes more sense:

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• Investment cost basis. This is how much you originally paid for an investment. The lower your cost basis, the larger your potential investment gain will be and the more valuable the step-up in basis becomes.

• Capital gains tax rate. The higher your capital gains tax rate is, the more you stand to save by simply holding your assets in a taxable account and preserving the step-up in basis.

• Dividend rate. If an investment pays a higher dividend (2%), it will carry a larger annual tax liability and may benefit from remaining in a Roth account. If the investment pays a low dividend or none at all, holding it in a taxable account and eventually capitalizing on the step-up in basis may be better.

• Life expectancy. A shorter life expectancy means you’ll pay fewer total taxes on dividends going forward. It also means your heirs will potentially receive their inheritance sooner.

How to Decide Between Selling Taxable or Roth Assets

So how do you determine between preserving taxable assets for the eventual step-up in basis or selling those assets to meet your retirement income needs?

First, the company says to calculate the cost basis percentage for your taxable investments. You can do this by simply dividing the cost basis – how much you originally paid for the asset – by its current value. For example, say you bought $10,000 worth of stock that’s now worth $14,000. Your cost basis percentage would be about 71%.

Next, compare your cost basis percentage against the break-even points that T. Rowe Price has calculated. If your cost basis percentage is below the break-even point, it’s worth holding onto your taxable assets and selling your Roth investments, instead. If it’s above the break-even point, selling taxable assets and forfeiting the step-up in basis is the better move.

For example, a person who pays the 20% long-term capital gains tax (and has qualified dividends) should preserve their taxable assets if their cost basis percentage is below 75%, and sell Roth assets to meet their income needs. Above that threshold, the opposite is true.

For someone who’s subject to the 15% long-term capital gains tax (and also has qualified dividends), the break-even point drops to around 67%, according to T. Rowe Price.

The calculation gets a bit more complicated if your dividend rate is 2% or higher. As your life expectancy gets shorter and shorter, the break-even points get higher and higher. If these parameters apply to you, you’ll want to see where your cost basis percentage falls on T. Rowe Price’s break-even cost basis graph, here.

Bottom Line

The step-up in basis is a powerful tax loophole that can allow your heirs to assume the current market value of inherited property, including stocks and other investments. This means they won’t owe tax on the investment gains those investments experienced during your lifetime – only the gains that are realized after your death. But the step-up doesn’t not apply to retirement accounts, including Roth IRAs. T. Rowe Price has calculated break-even points to help retirees decide when to preserve their taxable assets for the step-up in basis and when to sell them to cover retirement income needs.

Tax Planning Tips

• A financial advisor with tax expertise can help optimize your tax strategy, saving you money in the long run. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• Thinking of relocating to a more tax-friendly state in retirement? Be sure to use our retirement tax friendliness tool to find out how the different states tax retirement income and how you may be impacted.

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