Retirement > 401(k)s & IRAs
Tips on inherited stocks
November 29, 2000: 6:05 a.m. ET

Your kids get a "step up" when you leave them shares
By Ed Slott
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NEW YORK (CNNfn) - Let's say you inherited some stock, and you've heard something about a tax break when you sell the shares.

There are many important issues when it comes to inherited stock, especially the step-up in basis rules. And when you're talking about inherited stock that has been in a 401(k), it gets even trickier.

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Step-up is an estate tax concept. When a person dies, the general rule is that all property that was owned by the decedent (the dead person) is included in his estate at the value of that property on the date of death. That value is also known as the fair market value.

In some cases, where the value of the estate property has declined since the date of death, the property can be valued at six months after the date of death if that lowers the federal estate tax.

graphicBecause the estate of the decedent values the property at fair market value, a beneficiary who sells estate property is entitled to use the fair market value as his or her cost in figuring out the gain or loss on the sale of those assets.

This special treatment is known in tax talk as a "Step-up" in basis. The stepped-up value is the fair market value, as opposed to the original cost of the asset. Often, this step-up will drastically reduce the income tax your heirs will pay when they sell the estate property.

If your heirs sell right after your death, there will generally be no gain on the sale, because the cost used to figure gain or loss will be stepped-up to the fair market value at the date of death. If the asset is sold right after that, the selling price would be about the same, eliminating any income tax for your heirs.

However, here is the key: Not all estate property is entitled to a step-up in basis. Many assets, including inherited IRAs, do NOT receive such treatment.

The NUA rule

Now, I'd like to go a step further and talk about what happens when you inherit stock that's been in a 401(k).

Many workers invest in company stock in their 401(k)s or other company retirement plans. At retirement, this company stock enjoys a special tax break known in tax parlance as Net Unrealized Appreciation, or NUA.

NUA is the difference between the amount the stock was purchased for in your company plan and the value of that stock when you withdraw it from your plan. If the cost of your stock in the plan was $10 and it is worth $100 when you withdraw it from your plan at retirement, then your NUA is $90. This is the appreciation on the stock while it was in your plan.

So let's say that during your life, you never sold the stock and at your death the stock was worth $150.

If your heirs sell the stock immediately after your death, regardless of how much the stock has appreciated, your heirs will still pay capital gains tax on the $90. Why is that? There are two different taxes here. The estate tax and the income tax.

The step-up rules basically say that if the government grabs you on the estate tax on certain property, your heirs will be relieved from the income tax on that property. The value will be included in your estate and subject to estate taxes, but for income taxes when the stock is sold, your heirs will receive a step-up from the value when the stock was distributed from the plan, to the value at the date of death.

If the stock is sold at the estate tax value, the taxable gain for your heirs will be the NUA, because the NUA does NOT receive a step-up in basis. However, any further appreciation from the date the stock was distributed will receive a step-up in basis.

Read Ed Slott's columns on the three most important decisions you'll make with your IRA: Choosing a beneficiary, picking a life expectancy and picking a distribution method.

Let's go another step in this example. Assume that instead of selling right after death when the stock was still worth $150, your heirs waited for several years and sold when the value had increased to $500. Their taxable gain would now be $440. The selling price was $500 and the cost was the same $60, netting a profit of $440.

The increase in value from the date of death -- the $150 -- to the sale date value -- $500 -- does not receive a step-up in basis. The only step-up allowed is the $50 increase in value from distribution date to the date of death.

Therefore, to compute the taxable gain for your heirs, the cost will be your original cost in the plan of $10 plus the allowable step-up of $50, which equals $60.

The trick to figuring out the taxable gain or loss for your beneficiaries on the sale of NUA stock is to know that the NUA does not receive a step-up in basis, but any appreciation from distribution date to date of death does receive a step-up.

Also, any appreciation from the date of death does not receive a step-up in basis. This can get complicated, but your beneficiaries must know how to figure gains and losses when they inherit NUA stock.  graphic

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Understand the rules about inherited IRAs - Nov. 8, 2000