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Inheritance: Non-Qualified Investments

July 16, 2018

Posted in Inheritance

Three weeks ago, in Part 1 we discussed inheritance from qualified accounts. Let’s continue this conversation with non-qualified accounts. Accounts are considered non-qualified if they do not qualify for any type of tax-exempt status. The two types of non-qualified investments covered here are taxable investment accounts and non-qualified annuities. Understanding the difference is important both for the owner during their lifetime and for the individual inheriting.

Before we go further, it is important to understand the terms ‘cost basis’ and ‘capital gain’.  From a very simplified view, cost basis is the amount of an original investment you have already paid tax on and will not be taxed on again. For example, if $100 is invested in a taxable account, the cost basis is $100. If the investment grows, my cost basis remains unchanged and the growth is considered capital gain. So, if over the next year, my account value has grown to $150, the cost basis remains $100 and the capital gain is $50.

Taxable Investment Accounts

Taxable investment accounts can be registered individually or joint with another person, such as a spouse. The registered owner of an account is responsible for paying taxes on any capital gains realized while they are living. If the owner decides to gift shares to another individual during their lifetime, the new owner would become responsible for taxes on any capital gain based on the owner’s original cost basis. However, if an individual inherits shares at the owner’s death, they will receive a step-up in cost basis. This means the value of the account as of the date of the owner’s death becomes the cost basis for the new owner. See the example below:

Event Value when Received Cost Basis Taxable Gain
Gift During Lifetime: $10,000 Apple Stock Original Basis = $5,000 New Basis = $5,000 $5,000
Inheritance at Death: $10,000 Apple Stock Original Basis = $5,000 New Basis = $10,000 $0

In the case of a joint account, when one of the owners passes, the amount of step-up in cost basis the other owner receives depends on whether they live in a community property state or not.  Residents of community property states[1] receive a full step-up while non-community property state residents receive a ½ step-up. Receiving a step-up in basis is a significant advantage to the individual inheriting a taxable investment account.

If an individual is charitably inclined, gifting appreciated assets during their lifetime to charity is a great way to get a tax benefit, but also not be negatively impacted by capital gains taxes. The charity, unlike an individual, is not responsible for taxes on the gains of the investment. Talk with your advisor if you’re interested in looking at your options.

Non-Qualified Annuities

Non-qualified annuities can also be registered individually or joint with another person. This type of account allows the owner(s) to have tax-deferred growth while they are living. Any capital gain realized in the account is deferred until distributions begin, similar to qualified retirement accounts. When an annuity owner passes, a non-spousal beneficiary must withdraw the entire account value over no more than 5 years. The beneficiary is responsible for paying taxes on all of the gain remaining in the account. Depending on the size of the contract and whether the owner had begun distributions, this can be a large tax burden for the individual inheriting. One exception is if the deceased owned the contract jointly with a spouse, the contract can be changed to the surviving spouse as owner and no distributions are required, similar to an IRA.

Non-qualified accounts offer benefits that allow you to grow your wealth and have supplemental savings to retirement plans. However, it’s important to have a plan and be sure your wishes for the account are realized both during your lifetime and after. Talk with your Planner to make sure you’ve planned appropriately.


[1] The nine community property states are AZ, CA, ID, LA, NV, NM, TX, WA, WI



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