Nothing in life is certain but death and taxes, and today we are dealing with both. One of the most common questions I hear from clients sounds something like this…
“I just want to know what my kids are going to have to pay in taxes when I die. Can you help me understand that?”
This article is written for two audiences.
- If you have assets you plan to leave to your heirs someday, this will help you understand what your children or grandchildren might actually owe.
- And if you are the one who stands to inherit someday, this will help you know what to expect.
The Big Misconception
Here is the good news. Most people assume inheritances are heavily taxed, and generally, that is simply not true. In most cases, an inheritance itself is not taxable. There are exceptions, such as very large estates that can trigger a federal estate tax, or living in one of the handful of states, like Pennsylvania, that taxes inheritances at the state level. We will walk through those exceptions, but for the vast majority of people, the inheritance itself passes without being taxed.
That said, there are real caveats worth understanding, so let us break down the different kinds of taxes that can come into play.
Federal Estate Tax
Estate taxes apply only to very large estates. As of now, the federal exemption sits at roughly 15 million dollars per person. Anything above that threshold could be taxed at a rate as high as 40 percent. That is a steep number, which is why families with estates near or above that level often work with professionals who specialize in reducing or managing estate tax exposure.
Estate taxes are technically optional in the sense that they only apply above the exemption amount, and one way to avoid them is to direct anything above that threshold to charity. Families with significant wealth do not always choose that route, and there are other legitimate strategies available to manage the tax rather than simply give the excess away.
It also helps to understand how annual gifting interacts with the lifetime exemption. Currently, you can give up to 19,000 dollars per year, per recipient, without needing to report it to the IRS. Anything above that annual amount does count against your 15 million dollar lifetime exemption. So if you gave a child 50,000 dollars in a single year, that gift would need to be reported on a gift tax return, though no tax would actually be due. It simply reduces your remaining lifetime exemption. Keep in mind these thresholds are set by current law and can change, so check the figures for the year that applies to you.
State Estate and Inheritance Tax
Some states layer their own estate tax on top of the federal one, and most tie their exemption to the same federal threshold. A smaller number of states, only seven or eight, have a separate inheritance tax that applies regardless of the size of the estate. These taxes are usually modest. In Pennsylvania, for example, the rate for a parent leaving money to a child is 4.5 percent, and transfers between spouses are typically tax free. Rates and rules vary widely from state to state, so it is worth knowing what applies where you live, or where you plan to retire.
Income Tax and Cash Inheritances
Receiving money from an estate is generally not treated as income. A simple cash inheritance is considered a gift, not earned income, so it does not show up on your income tax return. This is part of why cash tends to be one of the most favorable assets to leave your children. It is flexible, and in most cases, it comes to them free of income tax, state tax, and federal tax, within the limits described above.
Capital Gains Tax and the Step Up in Basis
This is where things get a little more interesting, and where a concept called cost basis becomes important.
Cost basis is simply the amount you originally paid for an asset, the amount you have already been taxed on before you ever bought it. If you buy a stock for 10 dollars and later sell it for 50, you owe capital gains tax on the 40 dollar gain, not the original 10.
Here is the valuable part. When you inherit a non retirement asset, such as a home, a stock portfolio, or a business interest, that asset generally receives what is called a step up in basis to its value on the date of death. In other words, if your parents bought a stock for one dollar a share and it is worth 1,000 dollars a share when you inherit it, your new cost basis becomes 1,000 dollars, not one dollar. If you turned around and sold it right away, you would owe little to no capital gains tax.
This is why getting accurate date of death valuations for every asset in an estate matters so much. Without that documentation, it can become very difficult years later to establish what the cost basis actually was, which can create real tax headaches down the road.
One important warning here. If parents add a child as a co-owner on a home or account during their lifetime to try to avoid probate, that child typically inherits the parent’s original cost basis, not a stepped up basis, because they were already a co-owner before the date of death. That can end up costing far more in capital gains tax than the probate process it was meant to avoid. This is one of several reasons advisors generally caution against adding children as co-owners simply to sidestep probate.
Inheriting Real Estate
Real estate follows the same step up in basis rule, which makes it a favorable asset to inherit. If you inherit a home and choose to live in it, there is an added benefit. If you live in the home for at least two of the following five years before selling, you may qualify for the capital gains exclusion available to homeowners, which can further reduce or eliminate tax on a future sale.
Inheriting Retirement Accounts
Retirement accounts work differently than cash or investment accounts, so this deserves special attention.
Traditional IRAs and similar tax deferred accounts are generally taxable as ordinary income when money is withdrawn. This is an area where I see costly mistakes. If you inherit a traditional IRA, do not take a lump sum distribution straight to your checking account unless the amount is relatively small. A full lump sum gets reported as ordinary income and taxed at your highest marginal bracket all in one year.
Instead, most non spouse beneficiaries can transfer the funds into an inherited IRA and spread withdrawals across what is currently a ten year window. Under current law, the account generally needs to be fully distributed by December 31st of the tenth year following the original owner’s death. Spreading distributions out, rather than taking everything in year one, can meaningfully reduce the total tax burden over time.
Inheriting a Roth IRA is a different story, and a good one. Roth IRAs are funded with money that has already been taxed, so distributions are generally tax free, both now and when you eventually withdraw funds. The same ten year rule applies, meaning the account must be fully distributed within ten years. The strategy here is often the opposite of a traditional IRA. Rather than withdrawing early, it often makes sense to let the money continue growing tax free for as long as possible, taking only the smaller required distributions along the way and a larger final withdrawal in year ten.
Non-Qualified Annuities
Non qualified annuities deserve a special mention because they do not receive a step up in basis the way other assets do. If 100,000 dollars was invested into an annuity and it has grown to 500,000 dollars, the growth, in this case 400,000 dollars, comes out first and is taxed as ordinary income. Only once you reach the original cost basis does the money come out tax free.
This can create a significant, unexpected tax bill for beneficiaries, which is why some advisors joke that you should never die with a large non qualified annuity. It is not really a joke though. The tax burden it leaves behind can be substantial. If you hold a large non qualified annuity, it may be worth spreading out distributions during lower income years to manage that future tax exposure.
Life Insurance
Here is some genuinely good news. Life insurance death benefits are generally received completely free of income tax. If you are the beneficiary of a life insurance policy, you typically will not owe income tax on that money at all, though estate tax considerations can still apply for very large estates. Certain life insurance strategies can even be used proactively to help cover future estate tax liabilities.
Inheriting a Business or Other Complex Assets
If you inherit a business interest, real estate holdings, a partnership, an LLC, or other complex assets, resist the urge to make quick decisions. Whether the business is closely held within the family or involves outside owners, you will need to think through valuation, whether to continue operating it, sell it to existing partners, or find an outside buyer. These situations benefit enormously from involving an accountant and an attorney early in the process rather than making a decision under pressure.
Understand Your Tax Implications
Before making any major move with an inherited asset, take the time to understand its tax consequences first. It is worth paying an accountant for a few hours of advice before you sell, transfer, or restructure anything. A financial advisor experienced in estate matters can also be a valuable partner here, though it is worth interviewing them to confirm they genuinely understand estate planning and taxes, rather than simply trying to sell a product.
A few things worth confirming for every asset you inherit. Know your cost basis, including whether a step up applies. Understand any distribution requirements, such as the ten year rule for retirement accounts, or specific beneficiary options an annuity contract may allow. And build a long term plan for managing the tax impact, both now and in future years. This is not a situation to navigate alone or to try to piece together from a search engine. Work with someone qualified who can look you in the eye and help you understand what is actually happening with your money.
A Few Biblical Reminders
As we close, a few thoughts worth keeping in perspective. Proverbs 21:5 reminds us that the plans of the diligent lead to abundance, while haste leads only to poverty. Careful planning matters, and it applies just as much to taxes as it does to any other part of stewardship.
Luke 14:28 tells the story of a man who did not count the cost before building a tower, or a king who did not consider whether his army could face a larger force. It is a picture of the importance of counting the cost and being prepared for what lies ahead, rather than being caught off guard.
Paul reminds us in Romans 13 to give what is owed, including honor and taxes, to those to whom they are due. If you owe taxes, pay them. That is not a debt worth avoiding or gaming. Where you can legally and legitimately reduce your tax burden, absolutely pursue that. But there is a real difference between wise planning and trying to cut corners with the IRS.
The Final Word
What you inherit matters more than how much you inherit. Understanding how to handle the potential taxes tied to an inheritance sets you up to steward it well, rather than being blindsided by a bill you did not see coming.
For parents thinking through their own estate, it is worth asking whether your current asset structure could be simplified from a tax standpoint. Would it make sense to move funds from a traditional IRA into a Roth IRA over time? Would directing charitable giving through taxable accounts, like an IRA, rather than through cash, be more tax efficient for your family? These are worthwhile questions to explore with a qualified advisor.
And for those who will someday inherit, know what you are receiving, understand how to plan around it, and remember there are professionals ready to walk through this with you rather than leaving you to figure it out on your own.
This article is part of a series on preparing for the great wealth transfer. As always, tax laws and thresholds change over time, so confirm current figures with a qualified tax professional before making decisions based on the numbers referenced here.
Disclosures: The topics discussed in this podcast are for general information only, and are not intended to provide specific investment advice or recommendations. Investing and investment strategies involve risk, including the potential loss of principal. Past performance is not a guarantee of future results. All information here in is from sources believed reliable, but is not guaranteed for accuracy or completeness. The team assumes no liability for any errors, omissions or actions taken based on this material.
Information is as of the date stated and subject to change without notice. Securities and advisory services offered through Geneos Wealth Management, FINRA/SIPC
