Don't Lose Your Stepped-Up Tax Basis

Summary:  Many people make the costly mistake of converting capital gain assets such as stock, mutual funds, and real estate into ordinary income tax "tax-deferred" assets. This results in a large income tax bill both before and after death. See the example below.

Ordinary Income Assets (Tax-Deferred) Are Costly

Assets which produce tax-deferred ordinary income, such as IRAs, all annuities, 401(k) have a very high income tax cost.

The reason is that ordinary income tax rates are higher than capital gain income tax rates. Therefore all distributions from these assets are taxed at the marginal income tax rate. This marginal income tax rate may be about 40% combined federal and Colorado income tax.

The biggest cost must be paid after the death of the owner. The reason is that these assets do not get a new fair market value at the time of death "stepped-up" income tax basis. This means that in essentially all cases, distributions will be taxed at 40% or more because of the marginal income tax rate of the beneficiary.

Capital Gain Income Assets Produce Lower Income Taxes During Your Life

Capital gain assets can be sold during your lifetime at a lower income tax rate, compared to ordinary income tax assets. That has always been the case under federal and Colorado tax law.

Capital gain assets income real estate, stocks, and mutual funds.

Capital Gain Income Assets Are Sold After Your Death at $0 Income Tax Cost

Capital gain assets receive a new "stepped-up" income tax basis equal to there fair market value at the time of your death.

This means that your heirs can sell your capital gain assets and pay zero income tax on the sale. The reason is that the income tax is forgiven because of the stepped up income tax basis at the time of your death.

Example of Income Tax on the Sale of Capital Gain versus Tax-Deferred Assets

For example, if you own pay $10,000 for some stock (or any other capital gain asset) and your heirs sell it for $100,000, there is no income tax due on the sale.

In contrast, if you put $10,000 into an IRA or annuity, and your heirs liquidate it and withdraw $100,000, the income tax will be due on the $90,000 of gain. Thus, income tax of about $40,000 must be paid.

Therefore, it is always a big mistake to sell capital gain assets and "invest" in tax-deferred assets. This is just one of several reasons that the purchase of an annuity is a big mistake.