Thinking Through A Taxable Brokerage Account Titling for Married Spouses with Large Age Differences
As a financial planner, I've observed that while many individuals have a solid grasp of retirement accounts like Traditional IRAs and 401(k)s, there's often confusion surrounding taxable brokerage accounts. These accounts, also known as non-IRA or non-qualified accounts, play a crucial role in a well-rounded investment strategy but are frequently misunderstood.
A taxable brokerage account is an investment vehicle that doesn't offer the tax advantages of retirement accounts. Unlike IRAs or 401(k)s, these accounts have no contribution limits and offer greater flexibility, allowing withdrawals at any time without penalties. However, they also come with specific tax implications, as you'll owe taxes on dividends, interest, and capital gains as they occur.
Taxable accounts are particularly valuable for investors who have maxed out their tax-advantaged retirement accounts or need access to funds before retirement age. However, the lack of tax benefits necessitates careful planning and management to optimize their use within your overall financial strategy.
In today's post, we'll explore a specific planning consideration that arises for married couples with a significant age gap between spouses. We'll discuss why, in some cases, holding highly appreciated investments in individual or jointly owned taxable accounts might be preferable to simplifying account structures.
Taxable Account Basics
In a pre-tax IRA, all withdrawals are subject to ordinary income tax rates, regardless of whether they originate from contributions or growth.
In contrast, taxable brokerage accounts offer more nuanced tax considerations. Contributions to these accounts are made with after-tax dollars, so you won't incur additional taxes when withdrawing those funds. However, any growth in the account is subject to taxation upon withdrawal. The tax rate applied depends on how long you've held the securities. For assets held for one year or less, gains are taxed at ordinary income rates. For assets held for more than one year, gains qualify for preferential long-term capital gains rates, which are typically lower than ordinary income tax rates (most commonly 0%, 15%, or 20%, depending on your income level).
The key point here is that a taxable investment account has a component that has not been taxed yet, and we'll explore the implications of this taxable amount when the account owner dies.
Taxable Accounts Receive Step-Up in Basis At Death of Account Owner
A major feature of taxable accounts that often goes overlooked is the step-up in basis. Current IRS legislation allows for unrealized gains in a taxable account to be stepped-up for the beneficiary at the account owner's death. A 'step-up in basis' means that the cost basis of inherited assets is adjusted to their fair market value at the time of the owner's death, potentially reducing capital gains tax for heirs.
However, the amount the taxable account is stepped up depends on various situational circumstances, most notably how the account was titled. The most common situations I see in the state of Tennessee (where most of our clients live) are taxable accounts registered as Individual Accounts or Joint WROS (With Right of Survivorship) Accounts. You can see in the diagram below how big of a difference the registration can make:
Given the significant tax implications of account titling, especially in terms of step-up in basis, it's crucial to consult with financial professionals when deciding how to register your accounts. This decision resides at the intersection of financial planning, tax preparation, and estate planning. While each professional might have important insights to add, generally, any of these professionals you already have on your team can be a great person to start the conversation with.
Why This May Be Important For Spouses with Large Age Differences
Consider a married couple, Robert (70 years old) and Tammy (55 years old). Robert inherited $125,000 in Apple stock from his father 10 years ago, held in an Individual taxable account. Today, those shares are worth $1,000,000. Robert draws some income from the account annually but intends to hold the Apple shares indefinitely.
As a financial planner, I often advise clients to consolidate and simplify their accounts when possible. For Robert, it might seem beneficial to add Tammy's name to the account for administrative ease and asset consolidation. However, this approach could be shortsighted in their situation.
In Tennessee, if Robert adds Tammy as a Joint owner and then predeceases her, she would only receive a 50% step-up in basis. While account consolidation has its merits, the difference in potential tax savings is substantial. Conversely, if Robert retains the shares in an Individual account and Tammy unexpectedly passes away first, there would be no step-up in basis at all.
Owning the shares in a joint account would ensure (under current legislation) at least a 50% step-up regardless of which spouse passes first. The greater the age difference between spouses, the more accurately one might predict which spouse will pass first, potentially informing the decision on how to title the account.
Deathbed Planning for Highly Appreciated Taxable Accounts
This issue often comes to the forefront when a spouse is diagnosed with a terminal illness. To prevent last-minute asset transfers, there's a one-year survival period required after a registration change for the step-up in basis rules to apply. This is sometimes referred to as the "boomerang rule."
For instance, if Robert holds his $1M in Apple shares individually, anticipating he would likely die first, but then Tammy receives a terminal diagnosis, he could still transfer the shares to her. However, she must survive at least 12 months for Robert to receive the full step-up in basis.
Side comment: While it may seem morbid to consider tax implications during a terminal diagnosis, in my experience, clients often reach out to discuss such matters shortly after receiving such news. Their primary concern is typically ensuring the continuity of care for their surviving spouse. Contrary to what we might expect, these financial conversations are more likely to arise than not in these difficult situations, as couples strive to secure their partner's financial future.
Conclusion
Highly appreciated investments in taxable accounts present unique financial and tax planning opportunities. For married couples with a significant age gap and substantial appreciated assets, it's crucial to have a clear strategy in mind. While the tax advantages of a step-up in basis are appealing, we need to balance this potential benefit with other considerations.
It's important to remember that holding onto investments solely for tax purposes can be risky. Companies that seem invincible today may not maintain their dominance in the future. Sears is a prime example - once a retail giant, it serves as a cautionary tale of how market leaders can falter. Similarly, while tech giants like Amazon, Apple, and Microsoft have generated substantial returns for many of our clients, it's unwise to assume they'll maintain their market leadership indefinitely.
A balanced approach might involve gradually realizing gains over time, taking advantage of the preferential long-term capital gains tax rates. This strategy can provide more flexibility and reduce concentration risk. However, as you age and your assets become more appreciated, you might find that titling your taxable account in a certain way could make a significant tax difference for a surviving spouse.
Important Note: This article primarily discusses tax implications for separate property states like Tennessee. Community property states have different rules regarding asset ownership and taxation, which can significantly impact estate planning and the step-up in basis rules discussed here. The information provided is not intended to be legal, tax, or financial advice. It is merely a starting point for those who this situation might apply to. Every individual's circumstances are unique, and the laws and regulations can be complex and subject to change. We strongly encourage readers to consult with their trusted legal, tax, and financial professionals to delve deeper into the details and understand how these concepts apply to their specific situation.