Understanding Roth IRAs and Stepped-Up Basis
When it comes to planning for retirement, understanding the intricacies of Roth IRAs and stepped-up basis can be crucial. Ed recently asked if funds in a Roth IRA receive a stepped-up basis for beneficiaries when the account owner passes away. The short answer is no, but there’s more to it than that.
The Cost Basis of Assets in a Roth IRA
The cost basis of assets held within a Roth IRA does not step up or reset to their current market value when the account owner dies. This is because stepped-up basis only applies to assets and property held outside of retirement accounts. However, this isn’t necessarily a concern, as Roth IRA beneficiaries don’t pay taxes on qualified withdrawals from the account anyway.
How Cost Basis Works
To understand why this is the case, let’s take a closer look at cost basis. The cost basis of an investment is the starting point from which you calculate your gain for tax purposes. It’s generally the price you pay for something, plus any transaction costs or expenses associated with making the purchase. When you sell an asset, the difference between the sale price and the cost basis determines whether you have a capital gain or loss.
The Stepped-Up Basis Concept
The stepped-up basis concept applies when assets transfer to an heir upon a person’s death. The basis of an inherited asset “steps-up” to the fair market value on the date of death, which can lead to significant tax savings for beneficiaries. For example, imagine a 90-year-old woman owns a piece of land she bought 60 years ago for $10,000. If the property is worth $180,000 today, the owner has a basis of $10,000, which means her gain (unrealized until she sells the property) is $170,000. If the woman dies and leaves the land to a beneficiary, that beneficiary’s basis will step up to the current fair market value of $180,000.
Roth IRAs and Taxes
Retirement accounts like Roth IRAs offer tax advantages that shield assets from taxes while they remain in the account. Dividends, interest, and capital gains generated within these accounts typically grow tax-deferred or tax-free. Taxes are only triggered when you withdraw funds, with traditional accounts subjecting withdrawals to income tax, while Roth accounts allow tax-free withdrawals if certain conditions are met. The tax treatment of IRA withdrawals is unrelated to the cost basis of the underlying assets.
Inheriting a Roth IRA
When your heirs inherit a Roth IRA, they will generally have to withdraw the value of that account within 10 years. If you leave it to a spouse, they will have the additional option of rolling it into an account in their own name and avoiding the 10-year rule. In most cases, your heirs will not owe taxes on those withdrawals if the account has been open for at least five years.
Planning for Retirement
Planning for retirement can be complex, but working with a financial advisor who specializes in retirement planning can help you put the pieces together. If you’re ready to find an advisor who can help you achieve your financial goals, consider matching with a fiduciary financial advisor today.
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