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When does it make sense to spend your taxable investments to fund retirement expenses versus holding those investments to pass on to heirs?
When an investment in a taxable account is sold, taxes are generally owed on the capital gain—the difference between the sale price and the original purchase price (also referred to as the “cost basis”). However, when you die, the cost basis is reset to the investment’s price on the date of death. This is known as a “step-up in basis,” and it effectively eliminates the taxes that would have been paid on any gain to that point.*
This rule can be a benefit for people with wealth beyond what they will need for personal spending in retirement. The challenge is deciding whether to spend the investments in the taxable account or hold them in anticipation of the step-up (spending other assets instead).
What you should consider
Let’s say you have the choice of selling stock (shares, mutual fund, or Exchange Traded Fund investments) in a taxable account or making a qualified withdrawal from a Roth account** (assuming the same investment, with the same characteristics, is held in both accounts).
Four Factors That Indicate You Should Hold Taxable Investments for Step-Up
Investment cost basis
Capital gains tax rate
Your life expectancy
Investment’s dividend rate
If you have a big unrealized gain in your taxable investment, a high tax rate, and you don’t expect to live long, holding on to that investment can benefit your heirs significantly.
Use the 70% Rule
If the investment doesn’t have a dividend, then your decision about whether to sell the investment or withdraw from the Roth is fairly straightforward. Divide the investment’s cost basis by its current value. If the cost basis is more than about 70% of the current value, sell the taxable investment; if it’s less than 70%, use the Roth.
If the investment does have a dividend, however, the amount of the dividend—along with your life expectancy—matters. Dividends are taxed every year and, if the investment will be held for a long time, this tax drag becomes meaningful for someone with a long life expectancy.
Having assets you can leave your loved ones is a good problem to have. Proper planning can help ensure your spending is as tax-efficient as possible. Here are some next steps to help you with this important decision
- Review the stock investments in your taxable accounts.
- Evaluate the four factors for each: cost basis, your tax rate, your life expectancy, and the investment’s dividend rate.
- Talk to your financial professional, who can help you evaluate your situation so you feel confident you’re making an appropriate decision.
* Exceptions apply.
** Generally, Roth IRA distributions are qualified if the owner is over age 59½ and the account has been open at least 5 years.
This material has been prepared for general and educational purposes only. This material does not provide recommendations concerning investments, investment strategies, or account types. It is not individualized to the needs of any specific investor and is not intended to suggest that any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or tax professional regarding any legal or tax issues raised in this material.
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