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.

While federal estate taxes and state-level estate or inheritance taxes may apply to estates that exceed the applicable thresholds, receipt of an inheritance does not result in taxable income for federal or state income tax purposes.

Nevertheless, all assets you inherit carry with them eventual, and sometimes very immediate, income tax concerns. To make well-informed decisions and handle an inheritance prudently, it is important to understand the type of assets you’re receiving, and the income tax concerns for each.

In general, you can think of inherited assets in 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 the potential income tax consequences for each category.

1. Cash and securities

In general, you do not owe income tax on cash you receive as an inheritance—but there is a caveat. If what you receive is not simply cash, but rather is the right to receive money that would otherwise have gone to the person you’re inheriting from, it’s possible you could owe income tax when you receive the amounts. This typically involves items like salaries, bonuses and interest received on a promissory note, which would have been taxable income to the decedent (i.e., the person you’re inheriting from) but never were reported on the decedent’s or their estate’s income tax returns. The amounts don’t escape income tax because of the decedent’s death. Instead, you end up paying the income tax as the recipient.

• Step-up in cost basis

When you inherit securities, your receipt of them does not result in income tax. In fact, you receive a benefit because the income tax basis of the securities gets updated to the fair market value of the securities on the decedent’s date of death (or six months later, if elected). This is referred to as the "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. And you could 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.

2. Retirement accounts

Retirement accounts, such as IRAs or 401Ks, are typically the most income-tax-sensitive assets you will inherit. If they are traditional accounts (and not Roths), the account holdings have not yet been taxed. The accounts were likely funded by non-taxed income or employer contributions, and earnings and appreciation in an account also will not have been subject to tax.

As a result, your withdrawals from the account will be considered income and you will need to pay income tax. In addition, depending on your relationship to the decedent and how you receive your interest in the account, IRS rules will require you to take withdrawals from the account over a certain period (usually 10 years).

Your options for inheriting an IRA will depend on a handful of factors:

Your spouse. If you are the beneficiary of your spouse’s traditional IRA, there's 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 take withdrawals starting at age 73 and you'll pay income taxes at that point. 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 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 age 73 if later.

Non-spouse. If you inherit a traditional IRA from someone other than a spouse, you generally will need to withdraw all assets from the IRA, and pay the resulting income tax, within 10 years of the decedent’s death. Following are the withdrawal requirements, depending on whether the person you inherited from was taking distributions:

• If the deceased owner was already taking RMDs

If you inherited an IRA from someone who was already taking required minimum distributions (“RMDs”), you are required to continue taking RMDs. The RMD amount is an IRS calculation based on life expectancy and market value of the IRA. The annual distributions for years 1-9 are calculated with the IRS single life expectancy table, using the younger of your age or the deceased owner’s age at their birthday in the year of their death. When you reach the 10th year, you must withdraw any remaining assets from the account.

• If the deceased owner was not taking RMDs

If the original owner did not have required distributions when the account was passed to you, then you have until the end of the 10-year term to deplete the inherited account. This would generally apply to original owners who passed away in 2020 or later prior to reaching age 72 or 73.

• 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, special-needs trusts, disabled or chronically ill individuals, or if the beneficiary is less than 10 years younger than the decedent. For those that meet the exception criteria, they are subject to an annual RMD calculated using their individual life expectancy, or in some cases, the owner’s life expectancy. Their tax implications would be based on the RMD plus any additional distributions during the year. 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. When the beneficiaries of an IRA are not individuals, the IRA generally needs to be paid out within five years of the participant’s death. But often a trust will qualify as a "see-through" trust, enabling the rules above for individual beneficiaries to apply. 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 the 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 situation is different. If an annuity provides for a death benefit, it typically will be treated like life insurance and not be subject to income tax. However, if you receive a survivorship right to a continuing annuity, the annuity payments you receive would likely be subject to income tax, like the other cash receivable mentioned previously.

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.