The Step-Up in Basis Strategy for Maximizing Tax-Free Inheritance

How the Step-Up Works and Why It Matters

Every investment has a cost basis - the price you paid to acquire it. When you sell an investment, you owe capital gains tax on the difference between your selling price and your original basis. Long-term capital gains rates in 2026 range from 0% (for taxable income up to $96,700 for married filers) to 15% (up to $583,750 married) to 20% above that. For high earners, the 3.8% Net Investment Income Tax adds to the burden, bringing the effective top capital gains rate to 23.8%. At death, a different set of rules applies. Under IRC Section 1014, assets included in a decedent's estate receive a new cost basis equal to their fair market value on the date of death. This new basis is the stepped-up basis. If you purchased stock in 1990 for $10 per share and it is worth $200 per share when you die, your heirs receive the stock with a basis of $200. If they sell immediately, they owe zero in capital gains tax - regardless of the $190 per share in appreciation that accumulated over 35 years. That appreciation is permanently eliminated from the tax system. For a portfolio that has appreciated substantially over decades, the step-up can represent hundreds of thousands of dollars in tax savings to heirs.

What Gets a Step-Up and What Does Not

The step-up in basis applies to capital assets that are included in your taxable estate. This includes individual stocks and stock funds held in taxable brokerage accounts, real estate (primary residence, rental properties, vacation homes), business interests, collectibles, and other capital assets. What does NOT get a step-up in basis is equally important to understand. Traditional IRA and 401(k) assets do not get a step-up. These accounts contain pre-tax contributions and deferred earnings that have never been taxed. When an heir inherits a traditional IRA, they owe ordinary income tax on every dollar they withdraw - the same tax the original owner would have owed. The $900,000 in the example above, if it were inside a traditional IRA instead of a taxable account, would generate a full ordinary income tax bill for heirs at rates of 22% to 37%. Roth IRAs are income-tax-free to heirs for a different reason - the contributions were already taxed, and Roth conversions were taxed at conversion. There is no step-up calculation needed because there is no income tax due on qualified Roth withdrawals. Deferred annuities are another exception. Deferred annuity gains do not receive a step-up and are taxable to beneficiaries as ordinary income when withdrawn.

The Strategic Implications: What to Sell and What to Hold

Once you understand the step-up, the strategic implication is clear: highly appreciated assets you do not need to sell during your lifetime are better candidates to pass to heirs than to sell yourself and pay capital gains tax. This creates a useful framework for retirement withdrawals. Rather than drawing down your taxable brokerage account indiscriminately, identify which investments carry the most embedded gain. Those are the candidates to hold and pass with a step-up. Investments with little or no embedded gain - or those that have declined in value - are more efficient to sell during your lifetime. The swap strategy uses this logic explicitly. During retirement, you sell investments in your taxable account that have lost value or have minimal gain (harvesting losses or realizing small gains at low or zero capital gains rates). You hold the investments with the largest unrealized gains and let them ride until death, passing the step-up to heirs. This maximizes what is effectively a permanent tax elimination. For assets you might donate to charity, the step-up creates an interesting comparison. If charitable goals exist, donating appreciated stock directly is efficient - you avoid capital gains and get the deduction. But if heirs would benefit more from the inheritance than a charity from the donation, holding the stock until death eliminates the same gain tax-free without reducing the estate.

• Hold highly appreciated assets in taxable accounts until death if you do not need to sell them - heirs inherit with a fresh basis and zero capital gains
• Draw retirement income from traditional IRA or 401(k) accounts before selling appreciated taxable investments
• Harvest tax losses in taxable accounts during market downturns - sell investments at a loss to offset gains
• Donate appreciated assets directly to charity if charitable goals exist - you avoid capital gains AND get the deduction
• The step-up does NOT apply to traditional IRA, 401(k), or annuity assets - those generate ordinary income tax for beneficiaries
• In community property states, 100% of jointly owned community property may step up at the first death rather than just 50%

Community Property States and the Double Step-Up

Married couples in community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) have an additional step-up advantage. In community property states, assets acquired during the marriage are generally considered equally owned by both spouses. When one spouse dies, the entire community property asset - not just the deceased spouse's half - may receive a step-up in basis. In a non-community property (common-law) state, only the deceased spouse's half of jointly owned assets steps up. A couple who bought stock for $100,000 and it grew to $500,000: in a common-law state, the surviving spouse gets a step-up on only half ($250,000), leaving a blended basis of $300,000 on the full account. In a community property state with a full double step-up, the entire $500,000 steps up - zero taxable gain remaining. For couples moving between states, particularly from community property to common-law states, understanding how the step-up will apply to assets accumulated during the community property period is an important estate planning consideration.

The Step-Up and Life Insurance in Estate Planning

Life insurance occupies a different position in estate planning than taxable investments. The death benefit from a life insurance policy is income-tax-free to beneficiaries under IRC Section 101 - not because of the step-up in basis, but because life insurance death benefits are explicitly excluded from gross income by law. This means an Indexed Universal Life Insurance death benefit is income-tax-free at any point - regardless of how much the policy's cash value grew during the insured's lifetime. Unlike a stock portfolio that requires holding until death to eliminate capital gains tax via the step-up, a life insurance death benefit is tax-free regardless of when death occurs. For estate planning purposes, the two tools serve complementary roles. Appreciated taxable investments are best held until death to capture the step-up. Life insurance provides a separate, income-tax-free bucket that does not depend on step-up timing and that delivers a specific, predetermined benefit whenever death occurs. For very large estates where the federal estate tax may apply (above $13.99 million per person in 2026), life insurance held inside an Irrevocable Life Insurance Trust can also be excluded from the taxable estate, providing a death benefit free of both income tax and estate tax. This is an advanced planning technique that requires coordination with an estate planning attorney.