What are the tax implications of inheritance?

Understanding Inheritance Taxes: What You Need to Know

Imagine receiving a sudden inheritance—a family home, investment accounts, or even a lump sum of cash. While this financial windfall can be life-changing, many people overlook a crucial factor: taxes. Do you have to pay taxes on inherited money? What about capital gains or estate taxes? Let’s break it all down so you can make informed decisions.

Do You Have to Pay Taxes on an Inheritance?

In most cases, you do not pay federal income tax on inherited assets. However, other taxes, such as estate tax, inheritance tax (in some states), and capital gains tax, could come into play. Understanding these taxes will help you avoid surprises and optimize your financial strategy.

Estate Tax vs. Inheritance Tax: What’s the Difference?

These two terms are often confused, but they apply to different aspects of inheritance:

• Estate Tax: Paid by the deceased’s estate before assets are distributed to heirs. The IRS only imposes federal estate tax on estates exceeding $13.61 million in 2024 (IRS.gov).
• Inheritance Tax: Paid by the beneficiary after receiving the assets. Only six U.S. states impose this tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania (Tax Foundation).

Which States Have an Inheritance Tax?

If you inherit assets from someone who lived in one of the six states with an inheritance tax, you may owe a percentage based on your relationship to the deceased. In general:

• Spouses are usually exempt.
• Children and grandchildren often pay lower rates.
• Distant relatives or non-relatives may face higher tax rates.

Capital Gains Tax on Inherited Assets

While you don’t pay income tax on an inheritance, you may owe capital gains tax when selling inherited assets, such as stocks or real estate.

Step-Up in Basis: How It Works

One significant tax benefit of inheritance is the step-up in basis. This means the asset’s value is reset to its fair market value at the time of the original owner’s death. If you sell the asset shortly after inheriting it, you may owe little to no capital gains tax.

For example:

• Your parent bought a home for $100,000 decades ago.
• At the time of their death, the home is worth $400,000.
• If you sell it immediately for $400,000, there’s no taxable gain.
• If you hold onto it and sell later for $450,000, you only owe capital gains tax on the $50,000 gain.

This step-up rule applies to stocks, bonds, real estate, and other capital assets.

Retirement Accounts: Special Tax Considerations

Inheriting a retirement account, such as an IRA or 401(k), comes with unique tax rules. Unlike other inherited assets, retirement accounts are subject to income tax when withdrawn.

Types of Inherited Retirement Accounts

• Traditional IRA/401(k): Distributions are taxable as ordinary income.
• Roth IRA: Withdrawals are tax-free if the account has been open for at least five years.

Required Minimum Distributions (RMDs)

Under the SECURE Act of 2019, most non-spouse beneficiaries must withdraw the entire balance of an inherited IRA within 10 years, potentially increasing their tax burden (Congress.gov).

How to Reduce or Avoid Taxes on an Inheritance

If you anticipate receiving or leaving an inheritance, consider these strategies to minimize taxes:

1. Gifting Assets Before Death

The IRS allows individuals to gift up to $18,000 per person annually in 2024 without triggering gift tax (IRS.gov).

2. Establishing a Trust

Trusts can help manage inheritance tax exposure and control asset distribution. A revocable living trust allows assets to pass outside probate, while an irrevocable trust can remove assets from an estate for tax purposes.

3. Converting Traditional IRAs to Roth IRAs

If you expect to leave behind a large retirement account, converting to a Roth IRA can help heirs avoid taxable withdrawals.

4. Selling Inherited Property Strategically

By taking advantage of the step-up in basis, selling assets soon after inheritance can reduce capital gains taxes.

Common Inheritance Tax Myths

Myth #1: All Inheritances Are Taxed Heavily

Most inheritances are not subject to federal income tax, and only high-value estates face estate tax.

Myth #2: Life Insurance Payouts Are Taxed

Life insurance proceeds are generally tax-free for beneficiaries, though estate tax may apply if the policy owner’s estate is large.

Myth #3: You Can Avoid All Taxes on Inherited IRAs

Even with careful planning, non-spouse beneficiaries must take taxable withdrawals from traditional retirement accounts.

FAQ About Inheritance Taxes

1. Will I owe federal income tax on my inheritance?

No, the IRS does not consider inheritances as income. However, estate tax, inheritance tax (in some states), and capital gains tax may apply.

2. How do I find out if I owe inheritance tax?

Check the state laws where the deceased lived. Only six states impose an inheritance tax.

3. Do I have to pay capital gains tax if I sell inherited property?

If you sell for more than the stepped-up basis, you’ll owe capital gains tax on the difference.

4. Can I refuse an inheritance?

Yes, you can disclaim an inheritance, but you must do so in writing within a certain timeframe, usually nine months.

5. How can I reduce taxes on an inheritance?

Consider gifting strategies, trusts, Roth conversions, and selling assets strategically.

Final Thoughts

Inheriting money or property can be a blessing, but tax implications can be complex. By understanding estate tax, inheritance tax, and capital gains tax rules, you can make informed decisions and possibly reduce your tax burden. If you’re expecting an inheritance or planning your estate, consult with a tax professional or estate planner to optimize your strategy.