If you are about to receive an inheritance, you likely have some unanswered questions about the process and how an inheritance is taxed. This quick reference guide can help you get started in planning for an inheritance, but cannot be used as a substitute for comprehensive personalized financial and tax advice. Please contact us to discuss your situation.
Is an inheritance taxable?
There is no federal inheritance tax for cash or property. However, some states have an inheritance tax. Iowa, Kentucky, Nebraska, Pennsylvania do have an inheritance tax which the beneficiary may be responsible for. Two states: 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. Ask your tax advisor whether this may apply to your situation.
How are inherited retirement accounts taxed?
Unlike inheritances of property or cash, the person inheriting a retirement account such as an IRA or qualified retirement plan (e.g. 401(k)) will often be responsible for paying income taxes on the funds when they are withdrawn. Any earnings attributed to a Roth IRA will generally be tax-free as long as a 5-year holding period has been met.
Will I owe taxes on inherited stock?
If you've inherited investment assets in a taxable account such as stock in a brokerage account, there's a decent chance you may have to pay capital gains tax when you sell the position. At a high level, here's how this works:
When an individual purchases securities, their basis is the purchase price. Later, when they sell the position in a taxable account, their gain is determined by their holding period and how much more they sold the position for. (Infographic: How a brokerage account is taxed)
However, when stocks are inherited, the beneficiary receives a "step up" in cost basis to the market value of the security at the time of death. When the stock is eventually sold, you will pay capital gains taxes on the difference between your inherited step up cost basis and the sale price. This is one reason why a brokerage account can be a good way to leave a legacy. (It is also worth noting that inherited real estate will receive similar step up cost basis treatment.)
If you sell at a loss, you can offset other investment gains plus an additional $3,000. If your loss is greater than this amount, it can be carried forward to future tax years. Further, the holding period for inherited securities is always considered long-term, regardless of when it was purchased by the decedent.
What should I do after inheriting an IRA?
If you've inherited an IRA, you will have several options available to you. These options will vary, however, depending on your relation to the deceased (most commonly, whether they were a spouse or parent), their age, your age, what type of IRA you've inherited, and whether distributions have already begun. Tax-deferred accounts require additional tax planning to help ensure there are no unintended tax consequences from distributions.
Under the Secure Act, which was passed in 2019, beneficiaries who inherit a retirement account from a non-spouse (e.g. a parent or relative) can no longer 'stretch' the distributions over their lifetime by taking required minimum distributions (RMDs). Instead, they will be forced to take the funds in 10 years. The change won't impact anyone who inherited a retirement account during 2019 or years prior.
If you've inherited an IRA, please contact us to review and discuss your options.
Are life insurance proceeds taxable?
As the beneficiary, you likely will not owe income tax on the death benefit from a life insurance policy. If life insurance proceeds are received in a lump sum, there will be no income tax due. However, if you elect to receive the payout in installments, the interest received will be taxable. Although installment payments can help less confident investors by providing an "allowance" for the proceeds, also consider working with an independent fee-only financial advisor to develop an investment management strategy that's tailored to meet your personal goals and maximize your wealth.
Darrow Wealth Management is a fee-only wealth management firm in Boston. Schedule a free consultation to learn more about how a comprehensive financial plan can help make the most of your inheritance.
Darrow Wealth Management does not provide tax and/or legal advice. Certain circumstances may require us to coordinate with your qualified tax and/or legal advisor.