December 10, 2021
Tax deferral is a good thing. Making deductible IRA contributions, delaying income, accelerating deductions—these are ways to pay less in tax now. Eventually the piper will have to be paid.
But there are a few tax-planning strategies in which the tax savings are permanent. Perhaps the best one of these is the step-up in tax basis at death. (Perhaps that is why President Biden proposed killing this tax break, but he has been rebuffed by Congress.). The tax basis of an inherited asset is its fair market value at the date of death of the original owner. That means that the tax on all the unrealized gain is forgiven and never will be collected. The theoretical offset to that savings is that the asset will be subject to the federal estate tax, which applies at a 40% rate. Given that the federal estate tax exemption is now $10 million (plus inflation adjustments), that tax exposure is very theoretical indeed for the majority of families. (Note, however, that the estate tax exemption will fall in half in 2026, and Congress has proposed accelerating that change to next January.)
Still, holding appreciated assets until death is not much of an active strategy. Here are other ideas to consider as the year concludes.
Avoid short-term gains
The tax rate on a capital gain from the sale of an asset held for more than a year is generally about half of that on the sale of something held for a year or less. This can create a quandary. Should an investor lock-in a gain by selling while the price is high, or risk a market downturn by waiting until the longer holding period is satisfied? No doubt, in today’s volatile financial markets, this call is often not an easy one to make. Still, a bias toward longer-term holding periods will lead to better overall tax results.
Use tax-deferred accounts wisely
There is a temptation to hold appreciating assets, such as stocks, in a tax-deferred account, such as a traditional IRA. Years of tax-free compounding are certainly attractive. On the other hand, all distributions from the traditional IRA will be taxed as ordinary income. There is no pref- erential tax rate for long-term holdings. What’s more, the basis step-up at death doesn’t apply to assets in retirement accounts. Accordingly, the better result for some inves- tors will come from owning their appreciating assets in a taxable account, and investing their IRAs in bonds and other income-oriented choices.
The zero tax on some capital gains
Taxpayers in the 15% tax bracket and lower pay no tax at all on their capital gains (up to the end of the 15% bracket). Should the taxpayer experience a year of falling into that low bracket, it’s a great time to harvest gains at no tax cost. The more likely scenario for an affluent family is in the realm of gifts. A grandparent who would like to give $15,000 to a grandchild, perhaps to help with higher-education expenses, would be well-advised to instead give the grandchild appreciated securities. Assuming that the grandchild has only nominal income, the stocks may be sold without any tax drag on the proceeds.
Convert to a Roth IRA
Conversion of a traditional IRA to a Roth IRA is a taxable event, and the tax can be substantial. However, with the Roth IRA all future income and capital appreciation have the potential of being fully tax free. Should a taxpayer find himself or herself in a lower bracket than usual, it well may be a good time to consider such a conversion.
See your tax advisors before making any final decision.