If you’re receiving an inheritance you may be wondering how it will be taxed. The answer will ultimately depend on a number of factors, such as the type of inheritance you are receiving (real estate, a retirement account, cash, etc.), your state, the size of the estate, and what you do with the assets you inherit. When discussing the tax treatment of an inheritance, keep in mind that some taxes are paid by the estate, while others will be paid by you, the beneficiary.
How an inheritance will be taxed and who is responsible for paying any tax due will vary. Depending on the type of asset inherited, you may be required to pay income tax on inherited stock or capital gains taxes. Estate taxes are typically paid by the estate, not the beneficiary.
There are five different types of tax that could potentially apply to an inheritance (although not all at the same time):
- Federal Estate Tax: Large estates may be subject to federal estate tax to the extent they exceed the exemption. The estate and gift tax exemption is $11.58 million per person in 2020. For married couples, that's a combined $23.16 million. The estate and gift tax exemption in 2019 is $11.4 million, or $22.8 for married couples. The current federal estate tax is 40%, so it is suggested that individuals and families take a careful look at their estate plans to understand their options. Any tax due is paid by the estate.
- State Estate Tax: A handful of states (including Massachusetts) impose their own estate tax and exemption amounts. The tax rate is much lower than the federal estate tax (in 2017 Washington state was the highest at 20%), but the exemption amounts are much lower. State estate tax may apply to residents or nonresidents - in the latter case it is usually because the decedent held real estate or other tangible personal property out of state. Any tax due is paid by the estate.
- Inheritance Tax: Only a few states have an inheritance tax, which is usually paid by the beneficiary: Iowa, Kentucky, Nebraska, Pennsylvania. New Jersey and Maryland have both an estate tax and an inheritance tax. There are exemption amounts which vary by state, and whether a tax is imposed at all may also depend on your relation to the decedent.
- Income Tax: Depending on the type of asset, federal (and possible state) income tax may be due on an inheritance. Withdrawals from assets in tax-deferred retirement accounts (like a traditional IRA or 401(k)) will be included in your ordinary income and subject to income tax. This is also true for withdrawals of any gain over the initial investment in non-IRA annuities. Distributions from a Roth IRA will be tax-free assuming the required holding periods are met. The beneficiary of these accounts will be responsible for paying any income tax due at their individual tax rate. Timing of distributions will depend on whether you inherited a retirement account from a spouse or a parent or other relative.
- Capital Gains Taxes: If a beneficiary inherits non-retirement assets such as a brokerage account, home, antiques/art/collectables, or other real estate, they will receive a "step-up" in cost basis. When these assets are inherited, the beneficiary's cost basis is increased, or stepped-up, to the market value of the asset at the date of death. When the asset is eventually sold at a gain, the beneficiary will pay capital gains taxes on the difference between the inherited step-up cost basis and the sale price. The holding period for inherited property is always considered long-term, regardless of when it was purchased by the decedent.
If you are receiving an inheritance, discuss your options with one of our Wealth Advisors today. Darrow Wealth Management is a fee-only wealth management firm and fiduciary.
The material contained in this article is for general information only and should not be construed as the rendering of personalized investment, legal, accounting or tax advice. Please consult a tax professional to evaluate the potential impact an inheritance might have on your overall tax situation.