Giving money to people you love should be a joyful experience. The same goes for receiving an inheritance. These moments shouldn’t be wasted by stressing about taxes.
At Advance Capital Management, part of our financial planning service is to coach people to think carefully about their futures. That includes what they think is the best way to pass on their wealth to support loved ones or charitable causes. At the same time, we help individuals appropriately incorporate an inheritance into their financial plans.
However, the question most people ask isn’t “What can I best do with this money?” Rather, their chief concern is, “Is my inheritance taxable?”
Let us help you answer that question by going through the tax consequences of some of the most common inheritable assets. Whether you are planning to pass on your wealth or are expecting to receive an inheritance, this article will give you a better understanding of what tax rules apply.
This article covers:
Are inheritances taxable?
Difference between inheritance taxes and estate taxes
Are inheritances taxable?
Yes. Inheritance taxes are not the same as income taxes. In fact, inherited assets are not classified as income for federal tax purposes. However, any subsequent earnings on the inherited assets are taxable, unless it comes from a tax-free source. For instance, heirs will have to include the interest income from inherited cash and dividends on inherited stocks or mutual funds in their reported income.
The person who inherits the assets pays the inheritance tax, and rates can vary based on the size of the inheritance as well as the inheritor's relationship to the deceased.
However, it's important to note that inheritance taxes are often avoided for a couple of reasons. For one, only six states impose this tax (Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania). Also, spouses of the deceased – and sometimes children – are typically exempt, meaning money and items that go to them aren't subject to inheritance tax.
This is a good reason for working with a financial adviser and estate planning attorney to navigate specific rules and taxes in your state.
The difference between inheritance and estate taxes
Inheritance tax and estate tax are two different things.
Inheritance tax is what the beneficiary — the person who inherited the wealth — must pay when they receive it.
The estate tax, sometimes also called the “death tax,” is a tax that’s levied on your assets once you pass away. Most people don’t have to worry about it because the lifetime exclusion amount is so high. In 202e, the federal estate tax ranges from rates of 18% to 40% and generally only applies to assets over $12.92 million. In other words, if your estate is less than that, your heirs are not required to pay federal estate taxes.
Annually, you can make an unlimited number of gifts of up to a certain amount ($17,000 in 2023) per person each year without incurring any taxes.
Is a cash inheritance taxable?
Cash is the simplest asset to pass on. The annual gift tax exclusion is $17,000 (2023) (or $34,000 for spouses splitting gifts) per recipient. You can give this amount to any number of people, per year, without having to pay the gift tax. Anything above this limit will reduce the individual’s federal lifetime exemption and require the filing of a gift tax return.
Giving away the maximum amount every year can be a meaningful way to transfer wealth to others and help reduce your estate’s value under the estate tax exemption.
Are inherited bank products taxable?
Inheritances in the form of cash are not taxable to the recipient at the federal level. That means funds in a bank account that you pass on are not taxable and the person who inherits the account does not have to report it on their federal tax return.
With a money market account, the heir may have to pay taxes on the interest earned while owning it and/or depending on the state they live in.
Similarly, when ownership of a certificate of deposit (CD) is passed on to an heir, the value of the CD – the deposit amount and interest earned through the date of death – is not subject to income tax. But interest earned after the date of the original owner’s death does count as income for the heir.
Are life insurance benefits taxable?
Typically, inherited money from a life insurance policy is not taxed as income. However, there are situations where the beneficiary may have to pay taxes on some or all the money received. For instance, a beneficiary may have to pay taxes on any interest the policy accrued. Or, when a death benefit is paid to an estate, the person or persons inheriting the estate may have to pay estate taxes.
Are inherited investments taxable?
When inheriting investments, your heirs may get to avoid having to pay capital gains taxes.
If you sold your investments, you would owe capital gains taxes on the amount they increased in value. But if you bequeath these investments and hold them until your death, your heirs receive what is called a step-up in basis. This means the investment is valued by the market value on the day you pass away. So, if your heirs sell soon after, they may owe little to no taxes on the appreciation.
For example, let’s say you bought shares of Acme, Inc. 20 years ago for $1 and decide to sell at today’s price of $101. The cost basis would be $1 with a taxable gain of $100 per share. But if your heirs were to inherit these shares today upon your death, the cost basis would be $101, so they would not be subject to the taxable gain of $100.
Are inherited retirement accounts taxable?
It depends on the type of account and the relationship between the deceased and the recipient.
Employer-sponsored retirement accounts (401k, 403b, 457, TSP, etc.) and Traditional IRAs
Generally, heirs must pay ordinary income taxes on withdrawals from an inherited employer-sponsored account or inherited traditional IRA. Spouses, however, may move the inherited assets to their own retirement account. Non-spouse beneficiaries (with some exceptions) are required to withdraw all the funds within 10 years of the original account holder’s death.
Heirs can typically withdraw funds from a Roth IRA tax-free. That’s because a Roth IRA is a retirement account that you fund with after-tax dollars. In exchange, your retirement withdrawals are tax-free, including your investment gains, as long as the account has been open for at least five years. This tax-free treatment continues when your heirs inherit the Roth IRA, making this an effective asset to leave behind.
As with other investments, the step-up in basis treatment applies to real estate, an appealing tax break if you’ve owned your home or other property for many years. The cost basis for your heirs would be the property’s market value upon your death. Your heirs could potentially sell the property owing little or no taxes.
The bottom line
An inheritance can be a blessing, but if you’re not careful, it can also be a tax curse. Be sure to find out what inheritance taxes apply in your state. Beneficiaries can only do so much to avoid inheritance taxes once they’ve inherited an estate. However, those leaving the estate can take steps ahead of time to ensure beneficiaries are in the best situation possible. We recommend that you work with a financial adviser to help guide your decisions.
Are you looking to pass on a tax-efficient inheritance to your children or favorite causes? This free guide can help you start building your financial legacy. You’ll learn about 8 common ways to effectively pass on wealth. Download it now: