When a client asks about inheritance taxes “it depends” are usually the first two words out of my mouth. Many people don’t realize that inherited assets— property, stocks, investment accounts, etc. —may be subject to taxes and that there are specific tax rules for each type of asset or account. So before you sell Uncle Oscar’s rare wine collection, make sure you know the rules!
We are not talking here about estate taxes. Estate tax is assessed on the total value of everything you own; real estate, stocks, bonds, retirement accounts, businesses, farms, land, and it even includes the death benefit values of any life insurance policies owned by you. With the recently changed estate tax rules, estate taxes will only impact singles with an estate of $11M or more, or marrieds (if they’ve completed proper planning) with an estate worth $22M or more. Needless to say, estate taxes will not affect most of us.
So, if we’re not talking about estate taxes, what are we talking about when we say ‘inheritance taxes?’ We’re talking about various types of income taxes owed on inherited assets. The new tax law has nothing to do with how to navigate this separate issue.
Regardless of the value of the decedent’s estate, you may still owe taxes on certain assets bequeathed to you. Here’s a checklist of the most common assets that are passed on to beneficiaries and information on the relevant taxes: Inherited IRAs: If you already have a Traditional IRA, 401(k) or other tax-deferred accounts like a 403(b) or SIMPLE plan, you know that the money inside these types of accounts has not been taxed yet. When you inherit these types of accounts and withdraw money, the amount withdrawn is considered income. Some people cash in these accounts and are surprised by the tax bill they get. Ouch. That’s not the kind of surprise you want to get. The good news is that there are ways to minimize the amount of taxes you pay. One way, if allowed by the plan, is to roll the decedent’s account over to an Inherited IRA account. With an Inherited IRA, you take required distributions based on your life expectancy. If you desire, you can take out more than this amount, but not less. You name your own beneficiaries with this option. With this approach, you only have to withdraw Required Minimum Distributions (RMDs) each year. Thus you may be able to stretch the income and taxes on the inheritance over the course of your life. If you need significantly more than the RMD amount, another way to reduce the tax impact is to structure it so you withdraw some of the funds at the end of one tax year and some at the beginning of the next. Inherited 401(k)s: You will have to pay income tax on the amount you withdraw from an inherited 401(k). The good news is some beneficiaries are eligible to roll over the inherited 401(k) to an Inherited IRA. A rollover, when done properly, is not a taxable transaction, as it is not considered a withdrawal. If you can’t do a rollover, in some cases, you can leave the money in the plan. When you will be required to take the money out of the 401(k) you inherit depends on whether you were the spouse and what his/her age was when they passed, and your age when they passed. For example, if you are a non-spouse beneficiary, some plans require you to take the funds out of the 401(k) no later than December 31 of the fifth year following the decedent’s death. The IRS sets a general set of rules the employer plan must follow, but the plan is allowed to be even more restrictive than that general framework. That means different plans have different rules. Most of the time you can roll the funds into an inherited IRA but you will need to check with the 401(k) plan administrator to see what options they allow. Inherited mutual funds and stocks: There are different tax rules for inherited mutual funds or stocks that are not held inside retirement accounts. Typically when you sell a stock or fund you pay capital gains tax on any gain that has occurred since you bought it. The amount you originally bought it for is called your cost basis . When you inherit these types of assets, for tax purposes, the cost basis is based on the fair market value of the fund or stock at the time of the decedent’s passing. This is commonly referred to as a “step up” in cost basis. So if your parent bought a stock for $100 and it was worth $200 at their death, for tax purposes, you can “step-up” the cost basis to $200. Here’s an interesting detail: you can choose the fair market value of the fund or stock to be the date of the decedent’s death or you can choose the fair market value as of six months after death; if you choose six months after, you have to choose this alternate valuation date for all assets. You will either have a capital gain or a loss depending on the difference between the cost basis and the value of the asset when you sell it. To estimate the taxes on cashing in inherited accounts of any kind, you can do a tax projection to see what taxes you will pay if you cash something in. Inherited home/property: When you inherit a home, the value of the home on the decedent’s date of death (or the fair market value six months later if you chose the alternate valuation date) becomes the cost basis for tax purposes. So if the house was worth approximately $200,000 at the decedent’s date of death and you sold it eight months later for $220,000 you will have $20,000 of capital gains to report on your tax return. However, and this is very important, you might be able to exclude up to $250,000 of gain if the deceased lived in the home for at least two of the last five years. Unfortunately, if there is a loss on the sale, you will not be able to use it as a deduction. A good tax preparer can help you figure all this out. Another important detail to note: if the decedent added you as a joint owner of the property, you may forfeit some of your step-up in cost basis. In our example where the house is worth $200,000, let’s assume the decedent was your parent and they bought the house for $100,000. Thinking they were doing the right thing, they added you to the title of the home. Now, upon their passing, you only get a step-up on half the value of the home. Their half of the home has a basis of $100,000, but your half has a basis of $50,000, so far tax purposes the basis is $150,000. Now, when you sell it, taxes may be owed on $70,000 instead of only $20,000. Yikes! Artwork and jewelry: If you inherit artwork, jewelry or collectibles and you sell them, again you will have to pay taxes on the net gain of the sale. There is a hefty 28% capital gains tax rate, as compared to the 15% to 20% that applies to most capital assets, on the sale of inherited collectibles. The value is based on the value at the date of death, or the alternate valuation date. Items in this category include anything that is considered an item worth collecting. Generally, rare stamps, books, coins, art, fine wine, glassware, antiques, etc., fall under the collectibles umbrella.
Related: The Best Retirement Investments for a Steady Stream of Income
A final few words of advice… After a loved one passes, and you are in mourning, regardless of how smart and savvy you are, you will be vulnerable not only because of your emotional state but simply because you will be learning about new and complicated topics. Don’t be fooled by creditors who may attempt to collect debts from family members of a deceased person. These claims should be made against the estate, not against you. You may also inadvertently fall prey to someone, learning of your recent windfall, trying to sell you investment or insurance products. Do not invest or buy insurance products without going through a comprehensive financial planning process.
Tax laws are complex. If you expect to receive an inheritance, this might be the perfect time to start searching for a qualified professional who can help you decide what to do based on your situation and future goals.