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What Assets Get a Step-Up in Basis at Death?

What Assets Get a Step-Up in Basis at Death?

With the death of a loved one, one question we often get is, “What assets are entitled to a step-up in basis and what assets aren’t entitled to a step-up in basis at death?” To define what we mean by step-up in basis, sometimes referred to as stepped-up basis, here is an example:

Your mother purchased 100 shares of XYZ company at $10 per share in 1950, costing her $1,000, which is her “basis.” She holds the shares without selling until she passes away in 2022. The share price is $1,000 per share at her date of death. 

Despite the fact that she has a significant gain of $99,000 in this example, the basis “steps up” on the date of death to the share price on that date – or $100,000. If the beneficiary of this stock decides to sell it a few months later, their basis is $100,000 and the gain or loss is simply the value of the shares sold minus the basis. For example, if they were sold at a value of $110,000, they would owe tax on $10,000 of capital gains (and in this case, short-term capital gains).

Examples of Assets That Step-Up in Basis

  • Individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs) held in taxable accounts.
  • Real estate – this includes many forms, such as multi-family residences, primary residences, vacation homes, and office buildings. 
  • Businesses and the equipment in the business.
  • Art, collectibles, home furnishings – such as antiques that may have increased in value.
  • Cryptocurrencies.
  • Non-fungible tokens, or NFTs.

Examples of Assets That Do NOT Step-Up in Basis

  • Individual retirement accounts, including IRAs and Roth IRAs.
  • 401(k), 403(b), 457 employer-sponsored retirement plans and pensions.
  • Real estate that was gifted prior to inheritance.
  • Tax-deferred annuities.

We encourage our clients to seek out the counsel of a qualified estate planning attorney to plan out their wishes and assure that they are making good choices regarding future taxation of their assets and avoiding unintended consequences of their actions.

– Clint Walkner

Note: We are not CPAs. Please consult a tax professional if you have any tax questions specific to your own personal situation.

What is Index Investing? History, Construction, Weightings and Factors

What is Index Investing? History, Construction, Weightings and Factors

The subject of index investing is one of the most popular topics of the investment industry. It is written about constantly in business magazines, newspapers, and websites and generally comes with the author’s opinion on the topic whether you are interested in their opinion or not. As often as it is covered, I rarely find a piece that explains indexes and index investing in an easy-to-understand way. The goal of this article is to provide a general overview of indexes, the differences in how indexes are constructed, including equal-weighted indexes versus market capitalization-weighted indexes, and passive and factor indexing strategies. 

A BRIEF EXPLANATION AND HISTORY OF INDEX FUNDS

One of the most notable indexes is the Standard and Poor’s 500, more often referred to as the S&P 500. Simply put, the S&P 500 tracks the stock performance of the 500 largest companies, primarily based in the U.S. Investment companies took this idea and developed a way to purchase this basket of 500 companies in one investment as opposed to buying each stock as its own investment. The index itself was created in 1957 and is used to provide a broad representation of the overall stock market’s daily performance. The Dow Jones Industrial Average, which is arguably the most well-known index, is made up of only 30 stocks and, therefore, gives a more narrow representation of the market. The first S&P 500 index fund was created by Vanguard in 1976. This was the beginning of an entirely new way of investing. The vast majority of index investments, including Exchange Traded Funds, that exist today have been created within the last 20 years

An Exchange Traded Fund (ETF) is a different form of index investing. The first ETF was created in Canada in 1990, with the first U.S. ETF created shortly thereafter in 1992. One of the fundamental differences between index funds and ETFs is that ETFs trade throughout the day on a given exchange and, therefore, have price fluctuations intraday. Mutual funds only change their price per share once per day after the market has closed. With ETFs behaving more like individual stocks, they tend to be more tax-efficient than mutual funds as well. 

THE EXPANSIVE WORLD OF INDEXES

Since the beginning of the 2000s, the index investing world has exploded with offerings. The bellwether indexes of large companies, mid-sized companies, and small companies have given way to more niche and exotic indexes such as cybersecurity, photonics, and global blockchain, to name a few. A recent estimate put the total number of ETF investment products at more than 7,000; however, the number fluctuates by the day. The splintering of the ETF market also creates challenges in comparing what appear to be similar index investments, only to find out they can be vastly different. If we look at three Small Cap US ETFs from Vanguard (VB), iShares (IJR), and Charles Schwab (SCHA), we find three very different investments.

This chart represents a one-year performance comparison between the three mentioned ETFs. While this is a relatively short time frame for performance, the chart highlights the drastic difference between these investments, even though they all appear to be similar by title. The biggest reason for this performance variation is the makeup of each of these investments, which represents a different investment philosophy. The Schwab ETF owns the most small-cap companies in its basket with 1,761, then the Vanguard investment with 1,560, both of which dwarf the iShares offering with 684 total holdings. These are three of the most popular, passively managed U.S. small-cap index investments. It is fair to say that not all small-cap index investments are created equal. 

INDEX CONSTRUCTION

The development of index investments has evolved drastically over the past two decades. Let’s start with the most basic – the S&P 500. The purchase of an S&P 500 fund will yield you a basket of the 500 largest, mostly U.S.-based companies. The methodology used to determine the 500 companies that make up the S&P 500 is agreed upon by the investment community as a whole, in that, the list of companies that make up the index is published and accepted. That said, the construction of S&P 500 index funds can be quite different because the relative weighting of each of the 500 stocks can be different. Many of the S&P 500 funds are market capitalization-weighted, meaning that the largest stock in the index holds the largest position within the fund. This, proportionally, happens all the way down to the 500th company in the fund. By purchasing a market-cap-weighted index fund, the investor should understand they are not getting an equal slice of all of the stocks in the 500. Currently, the top five companies in the 500 make up over 20% of the index. By comparison, an equal-weighted index fund will do just that – invest an equal amount across all of the stock in the index. Here is a chart to illustrate how the performance of these two strategies may differ by using the SPDR S&P 500 market-cap-weighted fund (SPY) and the Invesco S&P 500 equal-weighted fund (RSP). 

The one-year performance chart of these two investments ends in relatively the same place. However, a closer look at the chart will show how the two investments behaved differently throughout the year. This next chart, representing the five-year performance of both investments, shows the more dramatic separation. 

This isn’t to say that one method is superior to the other, but rather, to illustrate the differences in index investing as well as the importance of knowing what you own in your investment portfolio. 

PASSIVE VERSUS FACTOR STRATEGIES

In the infancy of index investing, the idea was to model a well-known stock or bond index and simply follow the performance of the stocks in the basket. This eliminated the need for dedicated portfolio managers to use their expertise to pick stock or bond winners for their portfolios. The logic was simple: Why try to beat the performance of said index year-in and year-out when you can participate in the performance of the index. This is the way it went for many years until the development of factor strategies. Factor investing was a groundbreaking idea that would theoretically take a good idea – index investing – and make it significantly better. Typically, factor strategies will start with an index and use factors such as profitability or price-to-earnings ratios to weed out underperforming companies and then rank the remaining companies in the index. The idea is centered around the thought that not all of the companies in any given index are solid investments. Why own the bad with the good? Of course, this idea also relies on the correct combination of factors to determine what defines a “good” company and what defines a “bad” company by way of their investment merit. While the past five years have been difficult for many of the factor investment strategies, there are also periods when they dramatically outperform.  

When index investing was created and began to gain traction in the 1990s, it was difficult to see where it might lead. Many investment ideas have come in quickly, had their day in the sun, and went away almost as quickly. Index investing is not one of those ideas. It is as popular today as it has ever been, and the daily creation of new funds is evidence of that growth. Investment companies will continue to tinker with different ways to package their index offerings and try to build a better mousetrap. But, in the end, millions of inventors still prefer to own the funds from the early days, and that isn’t likely to change any time soon. 

Nate Condon

2022 Investment & Market Outlook Guide

Syl Michelin’s piece is part of Walkner Condon’s 2022 Investment & Market Outlook Guide, a comprehensive reflection of 2021 and glimpse at the factors impacting the year ahead in 2022.

2022 Investment and Market Outlook Guide

2022 Investment and Market Outlook Guide

Walkner Condon’s team of experienced financial advisors explores key topics that are top-of-mind as we transition out of 2021 and into a new calendar year, featuring the market outlook and review from Syl Michelin, a Chartered Financial Analyst™. Other topics include index funds, sector & factor performance, a pair of U.S. expat-focused pieces, and more.

Below you can find a breakdown of the individual pieces in this year’s outlook. 

1. The Year of Impossible Choices: 2021 Market Recap & 2022 Outlook
Syl Michelin, Chartered Financial Analyst™

Through a lens of current and historical data, Walkner Condon’s resident CFA® explores the last year in the markets, with an eye on factors that may impact 2022. 

2. It Only Gets Harder from Here: Valuations, Bond Environment & Wage Growth
Clint Walkner

With a multitude of market highs throughout 2021 and a long stretch of gains post-2008 financial crisis, it would appear the “easy” money, if we can call it that, has been made. In this piece, Clint dives into the three main challenges as we move forward into 2022.

3. Reviewing 2021 Sector and Factor Performance and Positioning in 2022
Mitch DeWitt, CFP®, MBA

The markets were up routinely throughout 2021, but that doesn’t mean the gains were shared equally. Mitch discusses the sector winners (and losers) of the last year, along with what factors – things like high beta, value, and quality – had their day in the sun. He also goes into what might be on the horizon this year.  

4. Exploring Index Funds: History, Construction, Weightings & Factors
Nate Condon

The goal of this piece from Nate is to provide a general overview of indexes, the differences in how indexes are constructed, including equal-weighted indexes versus market capitalization-weighted indexes, and passive and factor indexing strategies.

5. Three Reasons to Look at Investing Internationally in 2022
Keith Poniewaz, Ph.D.

Though the U.S. dollar had its best year since 2015 in 2021, Keith explains several reasons to think about international investments in 2022, including the very strength of that U.S. dollar, valuations, and the rest of the world’s growth in GDP.  

6. Top Five International Destinations for U.S. Expats in 2022
Stan Farmer, CFP®, J.D.

One of our U.S. expat experts, Stan jumps headfirst into possible locations for Americans to consider in 2022 if they’re thinking about a move abroad – or even if they’re just wanting to dream a little bit. Stan covers ground in South America, Europe, and Asia in this thorough piece, perhaps his first crack at being a travel journalist in his spare time. 

Review and Outlook: Analyzing ESG and Sustainable Investing into 2021

Review and Outlook: Analyzing ESG and Sustainable Investing into 2021

Many clients ask how they can invest their money in a way that aligns with their values. As one might imagine, there isn’t a universal way to accomplish this because different people have different values. However, there are some basic criteria in the investment world to help investors better understand how their investments score from a sustainability perspective. The three main pillars that many publicly traded securities are scored are Environmental, Social, and corporate Governance (ESG). US SIF defines sustainable investing as “An investment discipline that considers environmental, social and corporate governance (ESG) criteria to generate long-term competitive financial returns and positive societal impact.” (For a more in-depth blog that covers the basics of ESG, feel free to read this piece).

One of the first things that people interested in ESG investing ask is “will I be sacrificing my returns?”. There are numerous studies out there that show that you do not have to sacrifice returns by investing in ESG. As a matter of fact, some studies show that ESG can add some downside protection in a portfolio. Keep in mind that when comparing an ESG portfolio to a “traditional” portfolio you should ensure that asset allocation, among other factors, is consistent for an apples-to-apples comparison. 

Let’s take a look at how ESG funds performed in 2020, specifically US large-cap funds. This chart compares the total return of the Nuveen ESG Large-Cap ETF (ticker: NULC) vs. the Vanguard Large-Cap ETF (ticker: VV) in 2020.

This shows that the fund that incorporated ESG (NULC) returned 22.47% in calendar year 2020 while a peer that did not include ESG screening (VV) returned 20.98% in 2020. 

Now let’s look at two ETFs from the same fund manager: BlackRock. One of their flagship products, iShares ETFs, have ESG and non-ESG versions. The following chart compares two BlackRock large-cap blend funds: iShares ESG Aware MSCI USA ETF (ticker: ESGU) vs. iShares Russell 1000 ETF (IWB). 

This chart is another example of an ESG fund outperforming a peer (by 1.77% total return) in 2020. It is interesting to note that many of these funds end up owning a lot of the same companies under the hood. As a matter of fact, eight of the top 10 holdings in ESGU and IWB are the same. These are companies that we are probably familiar with: Apple, Microsoft, Amazon, Google, Facebook, Tesla, and Johnson & Johnson. 

The previous two charts show examples of where US large-cap ESG funds showed superior performance in a single year, 2020. Let’s take a look back a few years. The chart below goes back to 2017 and uses a couple of the iShares ETFs that were discussed in the last chart and compares them to a second ESG fund, FlexShares STOXX US ESG Impact ETF (ticker: ESG).

Over this time period, ESG again outperformed. In this case, FlexShares ESG ETF provided a 96.68% total return, significantly higher than either of the iShares ETFs.

The primary takeaway from the last three charts is that in recent history, incorporating ESG has appeared to be favorable to investors. One reason is that the price of oil is down, and one of the first screens applied to ESG funds is to “get rid of big-oil, carbon-intensive companies.” But oil isn’t the only reason; that only addresses a single screen within the Environmental category. Don’t forget about the ‘S’ and ‘G’ of ESG. 2020 – the year of COVID, social unrest, and political division – is an example of when ESG factors have shown to outperform during a period of uncertainty. Of course, as investors, we know that ESG may not always outperform. But from a macro perspective, we are seeing a trend in the number of assets that are going into ESG funds. 

OTHER TRENDS IN ESG

The prior section took a look at ESG funds and their performance in very recent memory. This section will zoom out a bit and look at ESG trends over a longer period of time as well as the growth in the amount of ESG offerings and the inflows going into ESG funds. 

According to US SIF’s 2020 Report on US Sustainable and Impact Investing Trends, of the $51.4 trillion professionally managed assets in the US, $17.1 trillion (33.3%) are considered sustainable investment assets. Compare this to US SIF’s (then known as the Social Investment Forum) 2010 report where an estimated $3.07 trillion of the $25.2 trillion (12.2%) of professionally managed assets included sustainability criteria. Graphically, it is easy to see the growth of ESG over the last couple of decades.

ESG IN 2021

Investors have been taking note of ESG trends for many years now, and the “big dog” asset managers are not taking ESG and sustainability lightly. In the executive summary of the 2021 Long-Term Capital Market Assumptions report, JP Morgan states, “Whether climate change is tackled through less intensive usage of “brown” energy or greater investment in green energy, we see a positive economic outcome in aggregate from more sustainable investment…Clearly, there will be winners and losers, particularly as demand for fossil fuels levels off and eventually goes into reverse. But as with other long-term challenges, we expect that the adoption of sustainable technology will both lead to new innovation and increase efficiency.” BlackRock’s 2021 Global Outlook is much more to the point, stating “We prefer sustainable assets amid a growing societal preference for sustainability.”

ESG has become quite controversial within the world of employer-sponsored retirement plans. Many employees of companies that offer defined-contribution plans such as 401(k)s are asking for more sustainable investment options within the investment lineup of their plan. That’s especially the case as Millennials are accumulating more wealth and Gen Z is continuing to enter the workforce and participate in their employer’s 401(k) plan. However, the stance of the Department of Labor (DOL), is that they do not want ESG funds within a 401(k) investment lineup. They don’t explicitly ban an ESG-labeled fund from a 401(k), but a couple of press release comments make it clear where they stand:

“Plan fiduciaries should never sacrifice participants’ interests in their benefits to promote other non-financial goals.” – Acting Assistant Secretary of Labor for the Employee Benefits Security Administration Jeanne Klinefelter Wilson

“This rule will ensure that retirement plan fiduciaries are focused on the financial interests of plan participants and beneficiaries, rather than on other, non-pecuniary goals or policy objectives.” – U.S. Secretary of Labor Eugene Scalia

I doubt that we will see any major overhaul to investment lineups in 2021 by 401(k) plan fiduciaries due to the position that the DOL has taken. That said, if more and more employees continue to push for ESG options within their retirement plans, this could change over time.

If, over time, ESG proves to add shareholder and stakeholder value, there very well may be a convergence between ESG and “traditional” investing. In other words, analyzing ESG factors may simply be part of every money manager’s investment process. 

Mitch DeWitt, CFP®, MBA

2021 INVESTMENT & OUTLOOK GUIDE

This piece was part of Walkner Condon’s 2020 Review & 2021 Investment Outlook Guide, a comprehensive interactive PDF covering a wide range of subjects and trends, including the S&P 500, electric cars, and more. To read the full guide, please click the button below.