One of the most powerful provisions in the U.S. tax code is also one of the most easily wasted. The step-up in basis at death wipes out unrealized capital gains on most assets passed to heirs. For households with substantial appreciated holdings, getting the planning right can save heirs hundreds of thousands — sometimes millions — in capital gains tax.
The principle is simple. The execution is where most plans fall short.
The mechanic
When you die and an asset passes to your heirs (through your will, a beneficiary designation, or a non-grantor trust), the heirs receive a new cost basis equal to the asset’s fair market value on the date of your death. Any unrealized capital gain that built up during your lifetime is effectively erased.
A simple example. You bought $100K of XYZ stock in 1995. By the time you die, it’s worth $1M. If you’d sold during your lifetime, you’d have owed capital gains tax on $900K of appreciation. If your heirs inherit the position and sell the next day, their capital gain is zero.
That’s a one-time tax savings, on this example, of roughly $214K (23.8% federal LTCG + NIIT × $900K) — plus state.
What gets a step-up
Most appreciated assets:
- Stocks, bonds, mutual funds, ETFs held in taxable brokerage accounts
- Real estate
- Privately held business interests
- Collectibles
What does NOT get a step-up:
- Traditional / pre-tax retirement accounts (401(k), Traditional IRA, etc.). Heirs inherit your basis; distributions are taxed as ordinary income.
- Roth IRAs — but they don’t need it; distributions are tax-free anyway.
- Annuities — gains are taxed as ordinary income to heirs.
- HSAs (when inherited by a non-spouse) — taxed as ordinary income.
The planning implications
Once you understand which buckets get a step-up and which don’t, the spending order in retirement should change accordingly.
For households planning to leave substantial assets to heirs, the conventional withdrawal sequence (“spend taxable accounts first, then traditional, then Roth”) often produces a worse outcome than the alternative. The reason: spending taxable accounts first means selling appreciated assets and paying the gains tax during your lifetime — exactly the tax that the step-up was designed to eliminate.
A more nuanced sequence for charitable / legacy-oriented households:
- Take RMDs from traditional accounts as required (no choice).
- Spend cash and short-term bonds first — minimal embedded gains.
- Use QCDs to satisfy charitable giving from the IRA, reducing future RMDs without spending taxable basis.
- Tap traditional IRAs for non-essential spending where Roth conversions don’t make sense.
- Defer selling appreciated taxable holdings to preserve the step-up for heirs.
- Use Roth conversions strategically — pay tax from cash, not from the converted amount itself.
The exact sequence depends on individual circumstances, but the principle is: highly appreciated taxable holdings are the last assets to spend in life and the most valuable to pass at death.
The traps to avoid
Selling concentrated stock during life “to diversify.” If diversification is the only goal and the position is meaningful, sometimes the better answer is to hedge rather than sell — see The Concentrated Stock Position Problem. Or to wait until death and let heirs sell with stepped-up basis.
Joint titling that destroys half the step-up. In community property states (TN is not one — TN is a common law state), assets held as community property get a 100% step-up at the first spouse’s death. In common law states, only the deceased spouse’s share gets a step-up; the surviving spouse keeps their original basis on their half.
Funding bypass trusts (“credit shelter trusts”) with appreciated assets. Done historically to avoid estate tax, this can lock in the original basis and forfeit the step-up at the second spouse’s death. With current federal estate tax exemptions at $13.61M per person ($27.22M per couple), the bypass trust math has changed dramatically — many old plans should be reviewed.
Transferring appreciated assets to children during life. Gifts carry the donor’s original basis. If your goal is to help heirs, the same gift made at death (with stepped-up basis) is more tax-efficient.
When the step-up may go away
The step-up has been on Congress’s potential-revenue-source list for years. Various proposals have circulated to eliminate or modify it. None have passed. The current planning landscape assumes the step-up continues — but plans built entirely around it should have a backup if rules change.
What to do
- Review which of your accounts hold appreciated positions and the embedded gains in each
- Coordinate spending sequence in retirement to preserve the step-up where possible
- Re-evaluate joint titling, especially for households that moved between common law and community property states
- Have your estate attorney review old bypass trust language; many are outdated
- For HNW estates, model the after-tax outcome to heirs under different spending sequences
The step-up is one of the largest single tax benefits the code offers. Building a retirement plan that captures it deliberately — rather than incidentally — is the difference between an OK estate plan and a good one.
If you’d like to model the after-tax outcomes of different spending sequences in your situation, we’d be glad to help.
General educational information about the basis step-up rules under current U.S. federal tax law. Rules vary by state and change over time. Specific decisions require coordination with your estate attorney and tax advisor.