Understanding Federal Inheritance Taxes: Real Estate, Retirement Accounts, and More
Inheriting assets certainly can be a blessing, but when it comes to taxes, it can quickly become a complicated, even stressful ordeal. Understanding the tax obligations of your inheritance can help you make informed decisions about how to manage your inherited assets (and set you up for a much easier tax season).
Some of the most common questions I’m getting from clients lately have to do with inheritance taxes after the passing of a loved one. So let’s answer the most basic one first:
Do you have to pay taxes on inheritance?
In most cases, the answer is yes! However, different types of inheritance come with different tax obligations. There are many types of assets that you can inherit, from cash, to property, to retirement accounts, and more. So, let’s take a look at the more common kinds of inherited assets as well as how you can expect to be taxed for each.
Key Takeaways:
- Cash and life insurance proceeds are generally tax-free inheritances
- Inherited brokerage accounts benefit from the “step-up in basis” that can significantly reduce future tax burden
- IRAs and 401(k)s have special rules requiring distributions within 10 years
- Property inheritances receive the “step-up in basis” that can help reduce capital gains taxes
- Working with financial advisors and tax professionals is crucial for managing inherited assets effectively
- For information about inheritance taxes in Minnesota, check out this blog post
Types of Inherited Assets
When you’re listed as a beneficiary and someone passes away, you may inherit multiple types of assets. Here are some common types of inherited assets as well as their tax implications:
Cash and Life Insurance Inheritances
The simplest type of inheritance from a tax perspective is cash. When you inherit cash, it’s completely tax-free. Similarly, life insurance proceeds are generally a tax-free event. This means you can receive these types of inheritances without worrying about immediate tax consequences.
Inherited Brokerage Accounts
Brokerage accounts are handled differently than cash inheritances. When you inherit a brokerage account, the initial transfer is tax-free, but there are important considerations:
- Any interest or dividends earned after you inherit the account become taxable to you, even if they’re reinvested
- The stocks within the account receive a “step-up in basis” to their value on the date of death
- You can choose to keep the investments or sell them with potentially minimal tax impact
What is the Step-Up in Basis Benefit?
The step-up in basis for inherited assets is a significant tax advantage for beneficiaries. Here’s how it works:
Let’s say your father bought Disney stock decades ago for $100, and it’s worth $500 when you inherit it. Your new basis becomes $500 (stepped up from the original $100 purchase price). If you sell the stock the next day for $510, you only pay capital gains tax on the $10 increase – not the full $410 gain from the original purchase price.
This same principle applies to other inherited capital assets, like real estate. This is particularly beneficial for properties like houses and farmland that have been in the family for generations and have appreciated significantly.
Inherited Real Estate & Property
Real estate is one of the most commonly inherited assets. With the rising cost of housing and land, the capital gains tax on inherited property could make this kind of inheritance a very costly one for beneficiaries. But thanks to the step-up in basis benefit, this is not the case.
When you inherit property, you receive a step-up in basis to the property’s value at the date of death (Note that an appraisal is often needed to establish this new basis). This is great news for the inheritor, because it means you aren’t responsible for paying taxes on how much the property increased in value when your loved one initially bought it.
If you eventually decide to sell the property, you’ll only be responsible for paying capital gains tax on any appreciation that has occurred since you inherited it. Should you choose to keep the property and rent it out instead, any rental income generated becomes taxable to you.
Inherited Retirement Accounts: IRAs and 401(k)s
One of the most important things to remember when it comes to inheritance are the rules around inheriting retirement accounts like IRAs and 401(k)s. When you inherit one of these accounts, unless you are a spouse or another “eligible designated beneficiary,” you are subject to the 10-year rule outlined by the Secure Act 2.0.
What is the IRS 10-Year Rule?
The Secure Act 2.0 requires most beneficiaries to empty inherited retirement accounts within 10 years. In practice, this means:
- You must take Required Minimum Distributions (RMDs) each year
- These distributions might push you into a higher tax bracket
- Not taking the RMD and/or failing to empty the account within 10 years can result in major penalties
Special Considerations for Spousal Inheritance
Inheriting assets from a spouse comes with different rules.
Spouses can treat inherited IRAs as their own. They can continue making contributions to inherited retirement accounts, and the 10-year distribution rule doesn’t apply. Additionally, for jointly owned property, there may be a step-up in basis for half the value of the property.
In general, inheriting assets as a spouse is significantly less complicated than inheriting assets as a non-spousal beneficiary.
Recently Received an Inheritance? Here’s Who You Should Be Working With
Trying to manage the inheritance process on your own can be overwhelming and most often results in missed deadlines and penalties. That’s why I always encourage my clients to seek out professional guidance when it comes to inheritance.
- Estate attorneys manage the legal transfer of assets, ensuring all documentation is properly handled during the inheritance process.
- Financial advisors help you make informed investment decisions with your inherited assets and manage required distributions from retirement accounts.
- CPAs provide essential guidance on understanding tax implications and ensuring proper reporting of your inherited assets on tax returns.
Each of these professionals brings unique expertise that can help you maximize the value of your inheritance and stay compliant with all legal and tax requirements.
Common Mistakes to Avoid
When dealing with inherited assets, be aware of these common pitfalls:
- Missing Required Minimum Distributions from inherited IRAs (which can result in significant penalties)
- Not understanding what assets you’ve inherited and their tax implications
- Failing to obtain proper valuations for the step-up in basis
- Not consulting with financial advisors about inherited investment accounts
Tax on Inheritance: The Bottom Line
So, do beneficiaries have to pay taxes on their inheritance? Unless it’s cash or a life insurance payout, yes.
It’s important that you understand the tax implications of inherited assets if you want to inform decisions about your inheritance. Each type of asset comes with its own rules and considerations, and mistakes can be costly.
Working with qualified professionals can help ensure you handle your inheritance appropriately and maximize its value while staying compliant with tax laws.
Let Wood CPA Handle Your Inheritance Tax Questions
We know that navigating the tax implications of inherited assets can feel overwhelming, but you don’t have to figure it out alone.
At Wood CPA, our tax experts are here to help you understand your tax obligations and make informed decisions about your inheritance. With our tax planning and tax filing services, we can take the stress out of your inheritance so you can focus on what’s important. Contact us today to schedule a meeting and find out how we can help you.
