Inheriting wealth: When will inheritance result in income tax?

Receiving an inheritance can come with a number of questions. One of the first questions many people ask is whether the inheritance will result in income tax to them.

In general, receiving an inheritance does not result in taxable income for federal or state income tax purposes. Depending on the type of asset you receive, however, income tax may come into play later, such as when an asset is sold, a retirement account is distributed or income owed to the decedent is later paid. To make well-informed decisions, it is important to understand the type of assets you’re receiving and the income tax considerations that may apply to each.

While inherited assets can include operating businesses, partnership interests, private investments and other specialized holdings, most inheritances fall into six general categories:

1. Cash and securities
2. Retirement accounts
3. Real estate
4. Art and collectibles
5. Life insurance and annuities
6. Interests in trust

Here are some potential income tax consequences for each category. 

1. Cash and securities

Cash

The cash you receive as an inheritance is generally not subject to income tax—but there is an important caveat. If you receive the right to collect income that was owed to the decedent but had not yet been taxed, that income may be taxable to you when received. This can include items such as unpaid salary, bonuses, or interest on a promissory note. These amounts do not avoid income tax simply because of the decedent’s death; instead, the tax obligation passes to the recipient.

Securities

When you inherit securities, your receipt of them does not result in income tax. One of the greatest tax benefits of inheriting securities is that their income tax basis is adjusted to the fair market value on the decedent’s date of death. (or an alternate valuation date if properly elected by the executor generally six months later). This is referred to as a step-up in basis and can be a tremendous benefit, especially if the securities were purchased at a low price and have increased significantly in value. This applies to publicly traded stocks and bonds.

For example, if you inherit shares in a company that were originally purchased for $100,000 and the value as of the decedent’s date death was $1 million, your income tax basis in the shares would be $1 million not $100,000. You could then sell the shares for $1 million with no capital gains tax. You would have capital gains if the shares continued to appreciate and you sold them for more than $1 million. What’s more, gains from the sale would be classified as long-term capital gains, even if you sell the shares shortly after obtaining them.

Conversely, if the shares had declined in value before death, your basis would be adjusted downward to their fair market value on the date of death. As a result, any decline in value that occurred during the original owner's lifetime cannot be claimed as a capital loss after you inherit the shares.

2. Retirement accounts

Retirement accounts, such as IRAs or 401(k)s, are often among the most income-tax-sensitive assets you can inherit. Unlike Roth accounts, which are distributed income tax-free if certain requirements are met, traditional retirement accounts typically contain contributions and investment earnings that have not yet been subject to income tax. As a result, these accounts do not receive a step-up in basis at death. Instead, distributions are taxed as ordinary income when they are withdrawn.

The rules governing when distributions must be taken and how they are taxed depend on several factors, including your relationship to the original account owner, the type of retirement account you inherit and whether the original owner died before or after their Required Beginning Date (RBD)—the date by which required minimum distributions must begin.

The rules for inherited IRAs depend on your relationship to the account owner.

Spouse. If you are the beneficiary of your spouse’s traditional IRA, there are generally two options for how you handle the account:

• Rollover into your own IRA. As a surviving spouse, you can roll your spouse’s IRA into your own IRA. You will be required to begin taking Required Minimum Distributions (RMDs) when you reach your Required Beginning Date (RBD). Under current law, your RMD age is 73 if you were born between 1951 and 1959, and 75 if you were born in 1960 or later. You will pay ordinary income tax on distributions when they are taken. This is often the preferred choice since it provides greater flexibility in the deferral of withdrawals (and resulting income tax) and how you can leave the IRA to a beneficiary of your choice when you die.
• Rollover to an Inherited IRA. If you do not roll over the IRA to your own IRA, you can elect to be treated as the IRA beneficiary. Distributions will be required over your life expectancy, beginning the year after your spouse’s death or after your spouse would have attained RBD, whichever is later.

Non-spouse. If you inherit a traditional IRA from someone other than a spouse, the distribution rules vary depending on your beneficiary status and whether the owner died before or after their RBD. Most non-spouse beneficiaries are subject to a 10-year distribution rule.

• If the IRA owner died on or after their RBD

If the IRA owner died on or after their Required Beginning Date (RBD), you must continue taking annual Required Minimum Distributions (RMDs) during years one through nine. Those annual distributions are calculated using the longer of either your remaining life expectancy or the original owner's remaining life expectancy, as determined under IRS rules. Any remaining balance must be distributed by the end of the 10th year.

• If the IRA owner died before their RBD

If the IRA owner died before reaching their RBD, then you have until the end of the 10-year term to fully deplete the inherited account. This applies to original owners who passed away in 2020 or later prior to reaching RBD. Different distribution rules may apply if the original owner died before 2020, including the potential availability of "stretch" distribution options.

• If you inherited a Roth IRA

Original owners of a Roth IRA are not subject to the same required distributions that apply to traditional IRAs. If you inherited a Roth IRA from a non-spouse, you have until the end of the 10-year term to empty the account and there are no required minimum distributions. Distributions from a Roth IRA are generally tax-free if the Roth IRA was held by the original owner for at least five years.

• Exceptions to the 10-year rule for eligible designated beneficiaries

An exception to this rule applies for minor children of the IRA owner, disabled or chronically ill individuals, or if the beneficiary is not more than 10 years younger than the decedent. Certain trusts established for these beneficiaries also may qualify if they meet specific IRS requirements. For those that meet the exception criteria, they are subject to an annual RMD which is calculated based on their individual life expectancy, or in some cases, the owner’s life expectancy. Any additional distributions taken during the year may also be taxable. For the IRA owner’s minor child, they are required to take life expectancy payments until they reach the age of majority and then they would be subject to the 10-year rule.

Inheriting retirement accounts through a trust

If you receive an interest in a retirement account as the beneficiary of a trust or you are one of multiple beneficiaries, your options in handling the account and your interests will require an additional layer of analysis. 

In many cases, a trust will qualify as a "see-through" trust, enabling the rules above for individual beneficiaries to apply. A see-through trust may be structured as either a conduit trust, which generally requires retirement account distributions to be passed through to the trust beneficiary, or an accumulation trust, which may allow distributions to remain in the trust. Accumulation trusts can provide additional control and asset protection, but retained income may be subject to compressed trust income tax brackets.

If a trust does not qualify as a see-through trust, it is generally treated as a non-individual beneficiary. In that case, the account may be subject to the 5-year rule if the owner died before their Required Beginning Date (RBD), or distributions based on the decedent's remaining life expectancy if the owner died on or after their RBD.

It is also important to note that if the decedent didn't take their full required distribution from a retirement account in the year of death, that distribution requirement and the resulting tax liability will pass to their successor. 

3. Real estate

Like securities, when you inherit real property the income tax basis is stepped up to the value of the property at the time of death (or if elected, six months later). If you decide to sell the property, you only pay capital gains tax on any appreciation over your stepped-up basis.

In addition, if the property becomes your personal residence and it does appreciate significantly after you inherit it, it is important to remember you can exclude $250,000 ($500,000 for married couples) of gain on the sale from taxes, as long as you own the house and use it as your principal residence for two of the five years before the sale. If you inherit the property from a spouse, you can use their period of residence to qualify for the two years.

When inheriting real property, it’s important to consider what you plan to do with the property as it can impact both the tax consequences stemming directly from the property as well as how you plan with your other assets to maximize your tax benefits.

4. Art and collectibles

Like securities and real property (and any other appreciated property), the income tax basis of inherited artwork and other collectibles is stepped up to the fair market value at the time of death (or six months later, if elected). For these items, which may include anything from paintings, sculpture, furniture, books, jewelry, silver or other tangible items with potential for value, it is important to obtain a professional appraisal to document the value. From a tax perspective, it is important to have appraised values if items are being donated to charity, so you document your deductions appropriately. It can also be relevant when items are divided among family members, both to ensure fairness, and avoid claims of de facto sales.

5. Life insurance and annuities

From a tax perspective, the great benefit of life insurance is that life insurance proceeds are not counted as taxable income, so beneficiaries do not pay income tax on them. However, if you take your benefits in installments over time rather than in a lump sum, the balance of the account may earn interest over that time, which would be taxable.

With annuities, the tax treatment is different. Some annuities include a death benefit that pays a beneficiary if the owner dies before or during the payout period. Unlike life insurance proceeds, these death benefits are generally not income tax-free.

If you inherit a non-qualified annuity and receive the proceeds as a lump sum, any unrecovered after-tax investment in the contract is generally returned tax-free, while any investment earnings are taxed as ordinary income. If you instead receive the annuity as a series of payments, each payment typically consists of both a tax-free return of your investment and a taxable portion representing investment earnings. The taxable and nontaxable portions of each payment are generally determined using an IRS exclusion ratio.

If the annuity is held within an IRA or other qualified retirement plan, the tax treatment is different. Because these accounts are generally funded with pre-tax dollars, distributions are typically taxed as ordinary income under the applicable retirement account rules.

6. Interests in trusts

In addition to receiving assets directly from a decedent or their estate, you may become the beneficiary of a trust as a result of a decedent’s death. For income taxes, it’s important to realize that assets in a trust will not receive a step-up in income tax basis if they were not included in the decedent’s estate for estate tax purposes. The assets and legal requirements of a trust also can vary, so communication with the trustee, or with legal and tax counsel if you are the trustee, is key.

Make the most of what you inherit

The good news is that inheritance is generally income tax-free. But that doesn’t mean you don’t need to be attentive to income tax when you inherit. In many cases, there are opportunities to save on taxes; in others, there may be pitfalls to avoid. Your Fiduciary Trust wealth advisor can help you work through the concerns and make the most out of what you inherit.