Understanding the Tax Implications of an Inheritance
When a loved one passes away, there are many financial decisions that need to be addressed. Anyone who has gone through this process will tell you that it can be overwhelming and stressful.
For those who have, or will be receiving an inheritance, it is important to understand the tax implications so you can make decisions that are consistent with your personal circumstances.
It is important to understand that while there is no “inheritance” tax in the US, there are two distinctly different types of taxes to consider including estate taxes and income taxes.
Estate Taxes: An estate must exceed $12.06 million in 2022 to be exposed to the estate tax in the US. Estate tax rates for estates that exceed this amount can be as high as 40%. The estate tax is generally assessed and paid by the “estate” before assets are distributed to the appropriate beneficiaries. Very few families are exposed to the estate tax in the U.S.
Income Taxes: There are no income taxes due upon receiving an inheritance. However, after inheriting the asset/account, there may be taxes due upon the sell or distribution of the inherited account/asset. Here is how various types of accounts or assets are treated from an income tax standpoint:
Real estate: Homes, farmland and other property owned by someone who dies, generally gets a “step-up” in cost basis. This means that the taxable portion of the property when sold by the beneficiary is the difference between the property value on the date of death (the “stepped-up” value) and the sales price. Income taxes may be due when the property is sold.
Personal Brokerage or Mutual Fund account: The cost basis of all the positions in the account would be stepped-up to the value on the date of death. Income taxes are due on the interest and dividends in the account as they are earned. Capital gains taxes are due as positions are sold within the account or distributed from mutual funds.
IRAs and 401k Plans: Income taxes are due as distributions are taken from the account. The entire distribution is taxed at the beneficiary’s ordinary income tax rate. Non-spousal beneficiaries are required to distribute the entire account within 10 years. Spouses can choose to roll these funds into their own IRA and follow their own distribution schedule.
Roth IRAs: There are no income taxes due when taking distributions from Roth IRAs. Non-spouse beneficiaries must distribute funds from Roth IRAs within 10 years. Spousal beneficiaries can roll these funds into their own Roth IRA.
Variable annuity (non-qualified): Income taxes are due as distributions are taken from the account. There are several distribution options to choose from including lump sum, 5 year stretch, etc.
Variable annuity (IRA): Like an IRA/401k, income taxes are due as distributions are taken and the entire balance must be withdrawn within 10 years for non-spousal beneficiaries. Spousal beneficiaries can choose to roll these funds into their own IRA and follow their own distribution schedule.
Life Insurance: No income tax is due on life insurance proceeds.
As you can see, there can be many planning decisions to make for those who receive an inheritance. Especially as it relates to the timing of required distributions and making tax-optimized investment shifts. Here are a few questions that should be considered:
Which of the next 10 tax years is best to take required IRA distributions? Is it more tax-efficient to distribute 1/10 of the inherited IRA each year, or to strategically take larger distributions in some years and avoid distributions in others?
When inheriting a non-qualified variable annuity, which payout option is the best choice? What impact will these distributions make on your taxable income and do you need to adjust your withholding, or make tax estimates?
Should you retain, or sell the individual stocks or mutual funds that were inherited? Do these positions align with your risk profile and return requirements? What is the most tax-efficient way to restructure your portfolio after an inheritance?
There are many decisions that need to be addressed after receiving an inheritance. Make sure that you understand your options and make the best choices that align with your personal circumstances.