Families that aren’t quite rich enough to be affected by the Estate Tax, but have built wealth over time, have another benefit available to them called the step-up-basis loophole.
Essentially, what happens with the step-up-basis loophole is when you pass on an investment to your beneficiaries, the present value at the time of your death becomes the new basis for that investment. This will wipe out the capital gains on that investment and can be a great deal which compares favourably to inheriting a Roth 401(k).
Anything over $23.16 million in your estate will be subject to a punitive estate tax of 40% when you die. But if you have an estate that is worth less than $23.16 million in your taxable bucket, that money can go tax-free to the next generation.
What happens to loopholes as time wears on? They become the target of a revenue-starved federal government.
There are four reasons why, while this may sound like it compares favorably with a Roth IRA, it is not the best idea.
If you receive dividends from one of your investments, even if you reinvest them back into the stock, you are going to have to pay tax on them which can stymie the growth of your stock portfolio.
Because you have to pay tax on those dividends, you are exposed to tax rate risk along the way. Should taxes raise dramatically over time, so will the taxes on those dividends. You also have to remember those dividends count as provisional income which could affect your social security.
The step-up-basis loophole is also going to come under fire as the country slides into insolvency and the government’s national debt starts to skyrocket.
Joe Biden is currently proposing that the step-up-basis loophole be closed, which would mean that you would inherit the original basis of the investment. This would also mean that you would have to pay long-term capital gains on the difference.
If you have an annual income greater than a million dollars, you would be required to pay the difference between the basis and the current value at your highest marginal tax bracket, which means you will be paying very close to the 40% estate tax that you wouldn’t otherwise be subject to.
Big taxes are coming down the road and letting your stocks grow in your taxable bucket will be a bad idea. Lawmakers have their sights on the step-up-basis loophole in the near future.
Some people believe the current tax law is even better than the Roth IRA because you won’t have the same requirement of spending the money down over the next ten years. If you are building your financial plan around this loophole being around for the next 10 to 15 years from now, you’re going to be disappointed.
We have to start looking at the four to six different streams of tax-free income for retirement. Life insurance has been around forever and like the loophole we are discussing, it allows you to pass money onto the next generation tax-free but won’t be in danger of being eliminated.
Make sure that you are maxing out your Roth 401(k)’s, Roth IRA’s, taking advantage of Roth Conversions, and funding your LIRPs. These are all things that are going to be immune from the tax changes coming down the pipe.
We are going to be looking at higher tax rates in the future, Republican or Democrat, it doesn’t matter. It’s just a question of time before the loophole is closed so we have to start planning with the expectation that it won’t be around when we die.