The Benefit of Tax Deferral and Stepped-Up Basis in Taxable Investments

Article excerpt

Tax deferral has long been recognized as a desirable strategy because of the time value of money. An economic benefit received today (i.e., taxes not paid) has greater value than an equal benefit received at some point in the future. Conversely, a cost incurred at some point in the future (i.e., taxes paid) is less detrimental than an equal cost incurred today. A cost that can be deferred and never paid is even better.

While most investors understand the benefits of tax deferral through a tax deferred investment vehicle, such as a 401(k) retirement plan, many may not appreciate the importance of deferring taxes in their taxable investment portfolios. Taxable portfolios are investments subject to current taxation on interest, dividends, and capital gains. In addition, many investors may not appreciate the significant benefit of stepped-up basis.

An "Interest-Free loan"

Unrealized gains in an investment portfolio are the capital appreciation that has not been cashed in. Untaxed capital appreciation creates a deferred tax liability, i.e., taxes deferred until the sale of the appreciated asset.

Deferred taxes are frequently called an interest-free loan from the U.S. Treasury. From this loan an investor benefits in two ways. First, the investor can earn income on the full amount of the invested principal, including the deferred taxes, until the appreciated asset is sold and the tax paid. The income generated may be subject to tax, but more invested principal equals more pre-tax income which equals more after-tax income. Second, the investor benefits from capital appreciation on the full amount of the invested principal, including the deferred taxes. Ultimately the appreciation may be taxed if the asset is sold, but there will still be a net benefit to the investor because of the growth on the full principal.

Stepped-up Basis

Holding assets until death results is a step-up in tax basis to fair market value at the time of death. Tax deferral on the unrealized and untaxed appreciation becomes tax forgiveness. The real value of a taxable portfolio at any point in time is the amount that would be realized on the sale of the portfolio, after capital gains taxes and costs, plus the present value of the capital gains tax liability that would be eliminated with a step-up in basis at death. For a younger investor, the present value is small. For an older investor, the present value is higher, indicating the importance of maximizing deferral to benefit from stepped-up basis.

Older investors may want to maintain control over their investment assets to protect their financial security in the face of future unknowns. But the reality is that many investors will not spend down their entire net worth during their lifetime and will leave substantial estates to heirs. Maximizing unrealized gains and tax deferral is an enormous benefit for the investor who will transfer a substantial estate to heirs.

In addition, the strategy of incorporating the possibility of stepped-up basis into investment planning results in significant benefits to investors, even if the investor doesn't hold the assets until death.

The Benefits of Deferral

The Exhibit demonstrates the benefit of tax deferral and stepped-up basis. The exhibit assumes an initial investment of $1 that earns a 10% annual compound return for 20 years. It shows the impact of various deferral scenarios as follows:

Line 1: Growth of $1 assuming the annual 10% return is fully taxed every year as long-term capital gain.

Line 2: Growth of $1 assuming the investment appreciates 10% per year for three years before the investment is sold, the appreciation is taxed as long-term capital gain, and the balance is reinvested.

Lines 3-5: The same calculation as line 2 for 5, 10, and 20 years.

Line 6: Growth of $1 at 10% per year for 20 years with no sale calculation because it is assumed to have received a stepped-up basis. …