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Tax Changes Could Come at Funds' Expense

The perceived tax advantages for those who inherit mutual funds has frequently been cited as a major reason for investing in mutual funds rather than variable annuities. However, recent tax law changes indicate that those advantages may be eliminated in the future.

For the past several years, the Internal Revenue Code has provided an unlimited step up in basis to beneficiaries who inherited mutual funds. A similar step up in basis is not available to beneficiaries who receive variable annuity proceeds from a deceased annuity owner. The word "basis" refers to the original cost of a mutual fund or variable annuity together with any upward or downward adjustments in such cost. The following example demonstrates application of the stepped-up basis rule where a mutual fund and variable annuity owner have died.


Abel purchased a mutual fund for $10,000. At his death, the fund was worth $80,000. Abel left the fund to his daughter Betty. Shortly after receiving the mutual fund, Betty sold it for $80,000. Betty will not incur any income tax liability on the sale of the fund because she is allowed to treat the inherited mutual fund as if she purchased it for its $80,000 fair market value as of the date of her father's death.

Stated another way, Betty's basis in her inherited mutual fund for income tax purposes would be stepped-up from her father's basis of $10,000 to the $80,000 date of death value. If Betty sold the fund for more than $80,000, she would be obligated to pay long-term capital gains taxes only on those sale proceeds that exceeded $80,000.

If Abel had purchased a variable annuity instead, his daughter would not have received a stepped-up basis in the annuity at her father's death. His $10,000 basis would be carried over to his daughter. If she sold the variable annuity, she would owe ordinary income taxes on all sale proceeds received above $10,000.

It is no secret that Congress is not a proponent of the stepped-up basis rule. Efforts to reduce or eliminate the rule have received significant support in Washington over the past few years. Certain investors who purchased funds years ago relying on the stepped-up basis rule to provide their beneficiaries with an income tax benefit, may be surprised to learn that this benefit is quickly being eroded. The stepped-up rule may have already been eliminated or reduced by recent tax legislation for a large number of mutual fund owners. The following example demonstrates this.


Ed, who is a 65-year-old widower, has real estate, stocks and bonds worth $1.3 million. He also has a mutual fund portfolio he recently purchased for $500,000. If these assets double in value and Ed dies in 2010, his heirs will not be entitled to a step up in basis in his mutual funds.

Many mutual fund owners believe that if the estate tax laws are restored in 2011, the prior unlimited stepped-up basis rule will also be restored. If this were to occur, trillions of dollars would pass from one generation to the next over a short period of time without being subject to income taxes. The likelihood that Congress would support such a large loss of revenue is remote at best.

Many tax experts, including this writer, predict further erosion or complete elimination of the stepped-up basis rule within the next few years. The loss of the stepped-up basis rule would have a negative impact on mutual fund investing which could result in increased variable annuity sales.

John Huggard is a guest columnist. He is an attorney and certified financial planner specializing in estate planning with the law firm Huggard, Obiol and Blake in Raleigh, N.C. Huggard is also a regular lecturer at North Carolina State University in Raleigh.