When a beneficiary inherits shares in a mutual fund, those shares may receive a stepped-up basis, which establishes the market value of the shares at the benefactor's time of death. Once the process is complete, and in the event the beneficiary sells the shares, that heir's cost basis becomes the net asset value of the shares at the close of the market on the day her benefactor dies.
To trigger the step-up in basis, the heir of the mutual fund shares provides the mutual fund company proof of identity and the death certificate of the original investor, as well as the probate court order and possibly other documentation. The company then adjusts the net asset value of the shares and either transfers the shares to the heir’s personal account or sells the shares and sends the proceeds to the heir.
Step-Up in Basis
It’s possible, perhaps likely, that the value of mutual fund shares which a beneficiary receives has appreciated in value between the time they were originally acquired and the point at which a beneficiary inherits them.
Following the heir’s inheritance of the shares, the adjustment of their value is termed a step-up in basis. When this occurs, the current, likely higher, net asset value becomes this asset’s basis for tax purposes. It amounts to the taxpayer’s investment in the shares. This new tax basis is used to calculate the beneficiary’s tax on inherited mutual funds upon their redemption.
Example of Tax on Inherited Mutual Funds
The step-up in basis reflects the change in value of the inherited shares in the mutual fund. For instance, assume that the original net asset value of the shares that a beneficiary inherits was $3 per share. Also, assume that following a step-up in basis, the value is $16 per share. Consequently, after the shares receive a step-up in basis, their cost basis equals the net asset value at the time of the benefactor’s death, which was $16.
Due to the step-up in basis, the capital gains tax the heir will pay at their redemption will be based on the $16 basis, rather than the share’s original net asset value of $3.
If a step-up in basis did not occur, the beneficiary’s tax on inherited mutual funds would be calculated on the difference between the initial net asset value of a share, or $3, and the share’s net asset value at the time of their redemption, or $16. Note this example does not account for any associated fees.
Benefit of Step-Up in Basis
A step-up in basis is applied to the original net asset value of mutual fund shares that are transferred at death to the owner’s beneficiary. The new net asset value of the shares that’s determined at the time of inheritance is considered the cost basis of the shares for tax purposes. Because the most recent net asset value is often higher than the original one, the step-up in value minimizes the beneficiary’s capital gains tax when she disposes of the shares.
Assuming the shares in the above example are redeemed at a price of $18 per share, if a step-up in basis had not occurred, the beneficiary would pay taxes of the difference between $3 per share and $18 per share, rather than the difference between $16 per share and $18 per share.
Read More: Estate Income Tax and the Step-Up in Basis
Tax Loophole on Inherited Mutual Funds
The step-up in basis tax provision is thought to be a tax loophole for the wealthy in that it eliminates or reduces the tax burden that results from the inheritance of an asset that has significantly appreciated in value over time. For example, a taxpayer can escape capital gains tax on stocks by placing the securities in a trust fund for their heirs.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.