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If you received an inheritance recently, you might be wondering how it affects your tax situation. The answer depends on the type of inheritance, when you received it and what your long-term goals are for the money.
First, determine the size of the estate you inherited. The good news is, thanks to the recent One Big Beautiful Bill Act (OBBBA), the federal estate tax exclusion is $15 million per person. Most estates are under this.
If the value of assets is more than $15 million, you could owe federal estate taxes in the amount of 40% on anything above that threshold.
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In addition, some states have estate taxes and/or inheritance taxes which you should be aware of (for example, Maryland has a 16% tax on anything above $5 million, and Pennsylvania has a variable inheritance tax from 0% to 15% depending on your relation to the deceased).
How inherited assets could be taxed
Once you’ve determined whether you owe estate taxes, you can move on to phase two — determining the type of asset and how it might or might not be taxed.
Cash. If you inherited cash (in a safe, a bank account, money market, etc.), there is no tax due. Keep in mind that any interest that accrued after the date of death would still be taxable at income tax rates.
Life insurance. Life insurance death benefits are always income and capital gains tax-free.
However, if you wait to claim the death benefit, the insurance company is required to pay you interest until you receive the claim, and this interest would be taxable, similar to a savings account (income tax rates).
Brokerage accounts/stocks, bonds and mutual funds. These accounts get a stepped-up basis upon death, meaning you won’t owe any tax if you sell them for whatever the value was at the time of death.
Any growth that happens after the date of death would be taxed at capital gains rates if you sell. Any dividends or interest payments may be taxed as long- or short-term capital gains.
Real property. Real estate also gets a stepped-up basis. However, since the value isn’t very easy to determine later, it’s important to get a valuation (usually a third-party certified appraisal) as soon as possible after the date of death.
This valuation is what you would use to determine if there are additional gains between the time of death and when you sell the house in the future.
If you intend to sell right away (within a year), you can skip the third-party appraisal and use the sale price as the estimated value of the house.
Gold/silver. This also gets a stepped-up basis. Capital gains (after the date of death) are taxed differently for gold and silver (your current income tax rate or a maximum of 28%, whichever is lower).
It would be useful to get a valuation done in case you sell it in the future, but there is no tax to inherit.
Annuities. Specifically for non-qualified annuities,* you have several options. For all these options, there is no stepped-up basis. You’ll ultimately owe income tax on any gains above the previous owner’s original contribution (basis).
For example, if the original contract owner put in $500,000 and the account was worth $1 million at the date of death, you would owe income tax on the $500,000 of growth. But the good news is you have several choices regarding when and how to pay those taxes:
- Lump sum. This is often the most inefficient; all taxes are due this year.
- Five-year rule. This is usually the default option; you can take as much or as little as you want out at a time, but the whole account must be drained within five years. The downside is that nonqualified annuities are taxed as “LIFO” (last in, first out) which means you have to take the taxable gains out before the tax-free principal.
- Annuitization. This exchanges the entire value of the current annuity for a guaranteed lifetime pension. There would be an exclusion ratio calculated based on your life expectancy, which means a specified percentage of the monthly payment is taxable and a percentage is always tax-free. The downside with this option is it’s irrevocable; you give up control of the money in exchange for the pension.
- Nonqualified stretch. This feels similar to annuitization, but it’s flexible and can be changed in the future as long as you take a minimum amount out each year. Payments aren’t guaranteed, but you can still earn interest inside the annuity that’s tax-deferred. In practice, this feels similar to a required distribution on an IRA.
* If the annuity is qualified (an IRA or Roth), throw out everything mentioned above and treat it the same as any IRA or Roth, as shown below.
IRAs/401ks. Prior to 2010, inherited IRAs and 401(k)s were possible to stretch like a nonqualified annuity. But after the SECURE Act, the qualified stretch was done away with.
Instead, we have the new 10-year rule for IRA distributions. Unless you are the spouse of the decedent (in which case you merge the IRA with your own), or unless you qualify for one of the few exceptions, you have 10 years to withdraw all the funds in the account.
During the 10 years, you’re required to take out at least as much as the decedent would have had to take out if still living (the required minimum distribution, or RMD). Anything left in the 10th year must be withdrawn in a lump sum.
Keep in mind that 100% of this money is taxable at your current income tax brackets, and there is no way to convert an inherited IRA to a Roth. (You could, however, convert it to life insurance over time to preserve tax-free access to future growth, if you qualify for the right kind of policy.)
It’s usually a good idea to not take only the minimum out, as that usually leaves a huge tax bill for the 10th year. But there is flexibility; you can take more or less out each year as long as you take at least the RMD amount.
Roth IRAs. Inherited Roth IRAs are now subject to the same 10-year rule as IRAs, just with no taxes (since Roth accounts are income tax-free).
Even though the deceased might not have had to take any RMDs, you as the beneficiary might have to take an RMD as if the money had been an IRA (just without the taxes).
It often makes sense to take only the minimum out, so as to get as much tax-free growth as possible on the inherited Roth up until the 10th year.
