Q: I have some mutual funds which my husband is against. He fears any risk. My daughter’s name is on them with me. I am 73 and wondering about withdrawing them before I get too old. If they are withdrawn, they will go into a regular bank account. If I die before I withdraw them, how would they affect my daughter tax wise?
— JB
A.: JB, There is no such thing as a risk-free holding but the risks that apply can vary so some investments are more appropriate than others. I’ll leave that discussion for another time and just focus on the tax consequences of getting out of mutual funds or inheriting the funds.
Having your daughter’s name on the account tells me the mutual funds are in a nonretirement or “taxable” account because IRAs cannot be owned jointly. There are several aspects to the taxation of mutual funds.
It is important to understand that you do not withdraw money from a fund like you would a bank account. Instead, you sell shares for cash and the cash is sent where you designate it to be sent. If you want $20,000 from a fund, you sell $20,000 worth of shares.
The taxes due on that sale depend on a few factors, the primary one being the cost basis. For the following examples, I will assume a mutual fund holding worth $20,000 with a cost basis of $10,000.
1. If you were to sell now to assuage your husband, the difference between the $20,000 in cash you receive upon sale and the $10,000 cost basis is capital gain. Typically, half the gain is taxed to each of the joint owners. If the fund shares were owned less than 12 months, the gain is short term and taxed as ordinary income. The federal tax rate on that tops out at 40.8% (37% + 3.8% Net Investment Income Tax)
If the fund shares were owned longer than 12 months, the gain is long term and taxed at more favorable rates. The rate on long term gains for some is zero and the maximum rate on long term gains is 23.8%.
Once the $20,000 is in the bank, your daughter could inherit it tax-free if your estate plan documents and paperwork are in order.
2. If the funds were owned in just your name and your daughter inherited the funds by will, trust, or beneficiary designation, she should inherit with little or no tax due to a step-up in basis. Your basis is adjusted or “stepped up” to its value on the date of your death. The basis would no longer be $10,000, it would be $20,000 so if the fund was then sold, the new $20,000 basis would equal the $20,000 from the sale and no gain exists.
3. If your daughter inherits the funds as a joint owner, the step up only applies to half the basis so instead of stepping up $10,000, the holding would only step up $5,000 creating a total basis of $15,000. The gain upon sale for $20,000 of shares would be $5,000.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
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