Posted on January 29, 2024 by Katherine Fox.

Does my inheritance count as taxable income?

Most inheritors won’t pay taxes on their inheritance. But not all. You could pay taxes on your inheritance depending on where the person who died lived and the type of assets you inherit.

Do beneficiaries pay estate tax on an inheritance?

Estate tax is a tax imposed on the total value of a deceased person's estate before it is distributed to the heirs. At the Federal level, estates over $13.61 million per person ($27.22 million for a married couple) are subject to estate tax. 

12 states: Washington, Oregon, Minnesota, Illinois, New York, Massachusetts, Connecticut, Rhode Island, Maine, Vermont, Maryland, and Hawaii have an estate tax, along with the District of Columbia. 

Estate tax is assessed on the entire estate's value, taking into account all assets owned by the deceased at the time of death. This includes real estate, investments, personal property, and other assets.

Estate tax is typically paid by the estate before assets are distributed to heirs. It is the responsibility of the estate executor or administrator to file the necessary tax returns and settle any tax liabilities.

If you inherit from a person who lived or owned property in one of the 12 states plus DC that have an estate tax, or if the person you inherited from had an estate greater than $13.61 million, then the estate may have to pay Federal or State estate tax. 

Inheritors are not responsible for paying estate tax. It is the responsibility of the estate itself, although it will reduce the overall amount you are inheriting. 

Do beneficiaries pay inheritance tax on an inheritance?

Inheritance tax is a tax imposed on the beneficiaries who inherit assets from a deceased person. Unlike estate tax, inheritance tax is not levied on the total value of the estate but on the specific amounts received by individual heirs.

Six states: Nebraska, Iowa, Kentucky, Pennsylvania, New Jersey, and Maryland have an inheritance tax. The tax applies to certain beneficiaries who inherit from a deceased person who lived or held property in the state with inheritance tax. 

Inheritance tax is assessed based on the value of the inherited assets received by each beneficiary. The tax rate and exemptions vary between states that impose inheritance taxes.

Inheritance tax is the responsibility of inheritors, who are required to report and pay the tax on the assets they inherit. The tax liability is specific to each beneficiary and is not settled by the estate.

If you inherit from a person who lived or owned property in one of the 6 states that have an inheritance tax, then you may have to pay inheritance tax. 

Inheritors are responsible for reporting their inheritances to the relevant states and paying their own inheritance taxes. 

The spouse of a deceased person is typically exempt from paying inheritance tax. Many states also exempt the children and parents of a deceased person. 

Does my inheritance count as taxable income?

Three reasons you could have to report an inheritance on your tax return:

1. You could have to report an inheritance on your tax return if the estate you are inheriting from is earning income.

If you are inheriting from an estate that has income producing assets, including dividend-paying stocks, real estate rental income, or cash-flowing alternative investments, you may see that income flow through to your personal tax return. Keep reading to learn more.

2. You could have to report an inheritance on your tax return if you inherit a pre-tax (traditional) IRA, 401k, or other retirement account.

You may not pay taxes upon receipt of a pre-tax IRA, 401k, or other retirement account, but they can cause tax issues for you down the road. Keep reading to learn more.

3. You could have to report an inheritance on your tax return if you inherit assets that didn’t get a step-up in basis.

One advantage for heirs when it comes to taxation of inherited assets is the step-up in basis. Under current tax laws, the cost basis of inherited assets is adjusted to their fair market value at the time of the decedent's death. This step-up in basis can result in substantial tax savings when the heir eventually sells the inherited assets. But not all inheritors will get a step-up in basis on inherited assets. Keep reading to learn more.

Your inheritance could count as income if the estate you are inheriting from is earning income.

If you are inheriting from an estate that has income producing assets, including dividend-paying stocks, real estate rental income, or cash-flowing alternative investments, you may see that income flow through to your personal tax return.

Income tax doesn’t stop when someone dies. Income earned by estate assets is tracked and reported on Form 1041, the tax return for trusts and estates. Often, this income flows through to estate beneficiaries’ personal tax returns. 

If you are an inheritor, you may owe income tax on money the estate generated. This is one of the biggest tax surprises that inheritors run into. Estate income is reported to beneficiaries on form K-1 and often beneficiaries don’t know to wait for this form before filing their taxes, creating an administrative headache.

If you are inheriting from an estate with income producing assets, you should ask your attorney or CPA if you should expect to see income from the estate show up on your personal tax return and when the K-1 will be available. 

Your inheritance could count as income if you inherit a pre-tax (traditional) IRA, 401k, or other retirement account.

You may not pay taxes upon receipt of a pre-tax IRA, 401k, or other retirement account, but they can cause tax issues for you down the road. 

All distributions from pre-tax retirement accounts are taxed as ordinary income. Most beneficiaries who inherit one of these accounts are required to fully empty the account within 10 years of the deceased person’s date of death. 

If you inherit a large retirement account, you could have a 10-year tax headache. Inheritors who live in states with income tax should pay special attention to tax planning, as income tax on IRA distributions could reduce the size of their inheritance by almost 50%.

Your inheritance could count as income if you inherit assets that didn’t get a step-up in basis.

If you inherit assets that generate income, you will pay taxes on the income generated as long as you hold the assets. 

This income could be from dividend stocks, rental property, bonds, or other sources. If you are not used to planning around investment income it can be a shock in the first tax year when your amount owed is higher than expected. 

You can reduce your tax liability by diversifying out of inherited positions that generate income and toward assets focused on long-term growth and appreciation. The ease of this diversification will depend on what the income-producing assets are and if you will realize capital gains upon their sale.

Do beneficiaries have to pay capital gains tax on inherited assets? 

One advantage of taxation on inherited assets is the step-up in basis. Under current tax laws, the cost basis of inherited assets is adjusted to their fair market value at the time of the decedent's death. This step-up in basis can result in substantial tax savings when the heir eventually sells the inherited assets. 

If an individual inherits assets that have appreciated since the deceased acquired them, the heir's capital gains tax liability is calculated based on the value of the stocks at the time of inheritance, not the original purchase price. This can lead to tax savings, especially for highly-appreciated assets. 

But not all inheritors get a step-up in basis on inherited assets. 

Beneficiaries may pay capital gains tax on inherited assets if they sell assets inherited through an irrevocable trust.

Assets inherited through an irrevocable trust generally do not receive a step-up in basis. This is because they are not owned by the decedent as of the date of death and are therefore not included as part of the total estate. 

If you inherited assets through an irrevocable trust, you will want to research the positions’ original cost basis and work with a financial advisor and CPA to determine how to sell out of assets in the most tax-efficient way possible. 

Beneficiaries may pay capital gains tax on inherited assets if they sell assets inherited by deed.

Depending on your relationship to the deceased person, the state you live in, and how assets are titled, you may not receive a full step-up in basis on property held jointly with the decedent. 

If you hold property Joint With Right of Survivorship (JTWROS) then the property will pass to you directly but you will only receive a step-up in basis on the percentage of the property owned by the deceased person. 

The same is true for most properties held as Tenants in common - the property does not pass to you directly but you will receive a step-up in basis on the 50% of the property owned by the decedent. 

How can I avoid reporting an inheritance on my tax return?

You can avoid reporting inherited assets on your tax return by holding inherited assets that didn’t receive a step-up in basis.

If you inherited through an irrevocable trust or by deed and did not receive a step up in basis, you can reduce your capital gains tax exposure by holding onto assets with a low cost basis. 

Building a tax-efficient plan to hold or slowly diversify these assets may be more appropriate than selling out in year 1 and paying the associated taxes. 

Inherited assets that didn’t receive a step-up in basis can also be used to make tax-efficient charitable donations. 

You can avoid reporting inherited assets on your tax return by increasing charitable donations.

Increasing charitable donations can reduce your overall tax burden from an inheritance in three ways:

• You may be able to deduct up to 60% of a large charitable donation from your adjusted gross income. 

• Gifting appreciated securities, rather than selling them and giving cash to charity, allows you to get low-basis assets out of your portfolio without realizing the associated capital gains. 

• Making a one-time gift of appreciated securities to a Donor Advised Fund combines these two strategies and allows you to take a large charitable deduction, remove appreciated securities from your portfolio, and fund your charitable giving for years to come. 
  

Let’s take the next step together

Understanding how your inheritance will be taxed is not easy. Beneficiaries 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 financial planner for inheritors to learn how Sunnybranch can help you build a plan to manage the tax consequences of your inheritance.