A complete guide to inheritance and taxes for younger inheritors
A complete guide to inheritance and taxes for younger inheritors
You’re here because you need to understand what the heck is going on with your taxes after you inherit.
Or, maybe, you’re planning ahead for a future inheritance.
In either case, I’ve got you. I’m Katherine. I’m a CERTIFIED FINANCIAL PLANNER™, a financial advisor for inheritance, and a fellow inheritor.
Keep reading for ESSENTIAL guidance on everything you need to know about inheritance and taxes.
Posted on Decmber 4, 2024 by Katherine Fox.
A complete guide to inheritance and taxes for younger inheritors
You just inherited from a loved one and now you're hit with a wave of tax-related questions.
Should you be setting aside money for taxes?
Will you owe the IRS?
Are there steps you should take right now to protect your inheritance from future taxes?
I get it.
The tax implications of inheritance can feel overwhelming.
As a financial planner and investment advisor who works exclusively with inheritors, I've noticed that tax questions are often the most stressful part of receiving an inheritance.
The good news?
Most inheritances come with favorable tax treatment – but you need to know the rules to make smart decisions.
This guide will walk you through everything you need to know about inheritance and taxes:
Are there taxes on an inheritance?
When is inherited money taxable?
How can I avoid inheritance or estate tax?
How much of my inheritance will be tax-free?
What can I do with inheritance money to avoid taxes?
Do trust beneficiaries pay taxes on inheritance?
Keep reading for 6 ESSENTIAL things inheritors need to know about taxes and inheritance
You’re closer than ever to finding answers to your questions and moving forward into managing the tax aspects of your inheritance with confidence.
I’m Katherine. I’m a CFP® and a financial advisor for inheritance.
I’m here to help you through this journey, whatever your needs are.
If you’re trying to get up to speed, check out the 20 Terms Inheritors Need to Know or How to Talk to Your Parents About Their End-of-Life or Estate Plan.
And if you’re deep in the weeds and don’t know what to do next, schedule a FREE consultation to see how I can help you figure out how to manage the tax consequences of your inheritance.
Are There Taxes on an Inheritance?
Short answer: maybe.
The language that inheritors usually use is asking about “taxes on an inheritance” but that’s at odds with how estate and inheritance tax works in the United States.
Let’s start simple: at the federal level, there is no inheritance tax in the United States. This means the federal government won't tax you directly on money or assets you inherit.
However, it is crucial to understand the difference between inheritance tax and estate tax.
Estate tax is paid by the estate before you receive your inheritance, while inheritance tax is paid by you as the beneficiary.
In 2024, the federal estate tax only applies to estates worth more than $13.61 million, meaning most estates won't owe federal estate tax. This leads to the common misconception that “inheritances aren’t taxed.”
Also, remember that estates themselves have to pay income tax on assets held by the estate - another tax that could reduce your total inheritance.
Complicating the picture, twelve states and the District of Columbia have their own estate taxes, often with much lower thresholds.
In addition, six states currently impose inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
If you inherit money from someone who lived or owned property in one of those states, you may owe state inheritance tax. The rates and exemptions vary significantly depending on your relationship to the deceased and the state's specific rules.
The type of assets you inherit also affects your tax picture after inheriting.
This discussion moves from the question of “will I have to pay taxes on receiving my inheritance” to “will I owe additional taxes as a result of the assets I inherited”
We’ve already discussed the answer to question #1, which can be boiled down to: “it depends.”
On the other hand, the answer to question #2 is almost always “yes.”
Keep reading to learn more.
6 ESSENTIAL things inheritors need to know about taxes on an inheritance
Keep reading to learn everything you need to know about how your inheritance may change your tax picture - now and in the future.
When is Inherited Money Taxable?
Almost all inheritors will owe more taxes as a result of receiving an inheritance.
Wondering how and why? Let’s walk through some of the most common scenarios I see:
Cash Inheritances
If you hold a cash inheritance in straight cash, it wouldn’t generate additional income tax. However, if you invest cash in an interest bearing account or in the stock market, you will pay taxes on those earnings.
For example, if you inherit $1 million and put it in a high-yield savings account earning 4% interest, that $40,000 in annual interest is taxable income.
Stock Inheritances in Taxable Accounts
If you inherit stocks or other investible assets held in taxable accounts, you may benefit from a tax benefit called the step-up in basis.
The step-up in basis increases the cost basis of inherited investments to their value on the decedent’s date of death, effectively erasing embedded capital gains for inheritors.
Here's an example:
Sarah inherited her father's tech stock portfolio that he'd bought for $100,000 in the early 2000s. By the time she inherited it, the portfolio was worth $1 million. Thanks to the step-up in basis, if she sold those stocks immediately, she would owe no capital gains tax.
If she decided to hold the portfolio and it grew to $1.2 million before she sold, she'd only owe capital gains tax on the $200,000 of appreciation that occurred after she inherited.
In the meantime, any interest earned from that $1 million stock portfolio would be taxable to Sarah as capital gains or interest income.
Real estate inheritance comes with its own considerations. Like stocks, inherited property can receive a step-up in basis to its fair market value at the time of death. This can be incredibly valuable if the property has appreciated significantly over time and you plan to sell.
If you instead decide to hold onto properties and rent them out, that rental income will be taxable to you. You will also pay property taxes and any other associated costs.
Inheriting an IRA or 401(k) is often the greatest source of tax headaches for younger inheritors.
Most Gen X, Millennial, and Gen Z inheritors are what is called “non-designated beneficiaries.”
This means that you will be required to fully empty any inherited pre-tax retirement accounts within 10 years.
An all of these distributions will be fully taxable at Federal/State ordinary income tax rates.
Depending on the size of the account, where you live, and how much you make, these distributions could reduce your inheritance from a pre-tax retirement account by almost 50%.
For example, consider the taxes if:
You inherit a $3 million dollar IRA
You and your partner live in California
You earn $600,000/year jointly
You may choose to withdraw at least $300,000/year to fully empty that account within a 10-year period. That $300,000 addition to your annual taxable income could be taxed at almost 45% - reducing the amount of your distribution by almost $140,000!
A note for inheritors of Roth accounts: distributions from Roth IRA or Roth 401(k) accounts are typically tax-free if the account was open for at least five years before the owner's death
How Can I Avoid Inheritance or Estate Tax?
First things first, once someone dies and you inherit, you can’t do anything to change the estate or inheritance tax due.
You can take steps to modify the amount of additional tax obligation your inheritance will create, but any estate or inheritance tax planning needs to be done BEFORE someone dies.
This is why it is critical to talk to your parents and loved ones about their wealth and estate plan starting early and often.
Most people don’t understand the full picture of estate, inheritance, and income taxes on inherited assets.
Educating yourself and bringing this information to your parents and loved ones can be an important first step in starting long-term conversations about wealth transfer in your family.
On a broad level, estate and inheritance taxes can’t be “avoided,” but they can be minimized through strategic planning.
If you expect to inherit from an estate that will owe federal estate tax (over $13.61m in 2024) talking to your parents about their estate plan is especially important.
This is also true if you live in one of the states (or DC) that levies its own estate tax. Some of these states have much lower exemptions - including Oregon, where only $1 million is exempt from state estate tax.
Once you have inherited assets, you have more control over your tax picture as an inheritor.
“Most people don’t understand the full picture of estate, inheritance, and income taxes on inherited assets.
Educating yourself and bringing this information to your parents and loved ones can be an important first step in starting long-term conversations about wealth transfer in your family. ”
How Much of My Inheritance Will Be Tax-Free?
Most inheritors aren’t going to pay significant taxes on their inheritance.
Generally (unless you live in a state with inheritance tax) your inheritance proceeds are tax-free - estate and other taxes have already been paid by the time you receive inherited funds.
However, this is a simplification of the tax changes that happen when you move from being a person with “regular” wealth to someone who inherited millions of dollars.
Practically, you will be dealing with many new tax considerations on an annual basis including:
Income from inherited investment accounts
Taxable income from retirement account distributions
Income and property taxes due on inherited real estate
Learning how to manage and pay estimated taxes when your income picture varies every year
Working with a qualified CPA and a financial advisor for inheritance is often a helpful step for new inheritors who are struggling to understand the tax consequences of inherited wealth.
What Can I Do with Inheritance Money to Avoid Taxes?
Tax reduction strategies after receiving an inheritance are the same strategies that wealth creators use.
Common options include:
Charitable Giving
Strategic charitable giving can create significant tax benefits while supporting causes you care about. Donor Advised Funds (DAFs) have become increasingly popular among my younger clients who inherit wealth. These funds allow you to take an immediate tax deduction while spreading your charitable giving over many years.
Tax-Efficient Investing
Tax-efficient investment strategies play a crucial role in managing inherited wealth. Asset location – placing tax-efficient investments in taxable accounts and tax-inefficient investments in retirement accounts – can significantly reduce your tax burden over time. Tax-advantaged investments (ETFs, Opportunity Zones, Municipal Bonds, et cetera) can also pay a role in a tax-efficient investment portfolio.
Starting a Business
Business creation offers another avenue for tax efficiency. If you are included to use your inheritance to start businesses, you can take advantage of tax deductions and credits that may be available to business owners.
Effective Long-Term Tax Planning
The key to tax efficiency lies in planning ahead to take advantage of good timing. For instance, if you inherit a traditional IRA, you might coordinate your distributions with your anticipated future income and career trajectory.
At Sunnybranch, I work with my clients to focus on making tax-efficient decisions that align with your overall financial goals and values.
The strategies that work best for you will depend on your specific situation, including the type of assets you inherited, your other income sources, and your long-term financial objectives.
Do Trust Beneficiaries Pay Taxes on Inheritance?
Trust taxation represents one of the most complex areas of inheritance planning.
As an advisor who works with many trust beneficiaries, I find that understanding these rules is crucial for making informed decisions.
Let’s walk through the key concepts you need to understand as a trust beneficiary.
First, let’s explain the different between inheriting assets through a trust and inheriting assets held in trust.
The initial tax treatment of your trust inheritance depends on the type of trust involved. Revocable living trusts, generally offer the same tax treatment as if you had inherited directly. These trusts provide a step-up in basis at death, meaning you won't owe capital gains tax on appreciation that occurred during the trust creator's lifetime if you inherit through revocable trust.
More commonly, young inheritors from large estates will inherit assets held in trust (note: these assets may also have been inherited through a trust, increasing confusion).
In this case, inheritors are beneficiaries of an irrevocable trust.
These trusts present a more complex tax picture because they are separate tax entities. When an irrevocable trust generates income, someone has to pay taxes on that income – either the trust itself or the beneficiaries.
Income distributed to beneficiaries is generally taxed at their tax rates and flows through to your personal tax return through form K-1.
Income retained in the trust is taxed at compressed trust tax rates that reach the highest brackets much more quickly.
As a trust beneficiary, you're not alone in navigating these complex tax rules.
Working with an inheritance financial advisor who understands both trust taxation and your overall financial picture can help ensure you're making optimal decisions about trust distributions and their tax implications.
The key is working with your trustee to develop a strategic approach that considers both your immediate tax situation and your long-term financial goals.
Let’s take the next step together
Understanding the tax consequences of your inheritance is not easy. Inheritors can encounter a wide variety of different situations requiring knowledge and finesse to manage. If you need more help, you can download The 20 Inheritance Terms You Need to Know, or reach out to Katherine Fox, CFP® and CAP®, a fiduciary, fee-only financial planner to learn how Sunnybranch can help you build a plan to manage, grow, and protect your inherited investments.
