Inheriting an
An account might bring taxes.
Time to ask for help.

If you receive an inheritance, one of the most important questions to ask is: “what kind of account did this come from?” All accounts have rules assigned to them in the tax code, concerning both how they can be used and taxed while held by the original account owner as well as how they pass to the owner’s heirs. Here are a few quick examples.

(Please note: the focus of this article is on Federal taxes. There are 17 states that impose estate and/or inheritance taxes. If you inherit money while living in one of those states, consider hiring a CPA to help decipher local tax codes and how to navigate them. Also, when this article discusses accounts passing to beneficiaries, we’re going to assume the estate in question falls below the Federal Estate Tax Exemption. In 2023 this exemption is $12.92 million for a single person, or $25.84 million for a married couple.)

Checking, Savings Accounts, and Bank CDs: Any interest generated by these accounts is taxable every year, and they can pass to beneficiaries through Payable On Death (POD) designations. The beneficiaries will owe no tax on the inheritance on the Federal level.

Individual Investment Accounts: These accounts are sometimes called “Individual TOD” accounts. The TOD stands for “Transfer on Death.” These accounts are taxable annually if any of the holdings generate interest, dividends, or capital gains. If you have a relative who owns stock, it is probably held in an account like this. After the death of the account owner, if a TOD designation is in place, assets in the account will bypass probate and become an asset of the named beneficiary.

When you inherit a taxable investment account like an Individual TOD account, you will receive a full step up in basis. This means that the amount of after-tax money contributed into the account gets reset to the account balance at the time of the account owner’s death.

For example, some lucky person may have invested $10,000 in a low-priced tech stock in the early 2000s. This is the account’s basis. By 2023, that $10,000 has grown to $10,000,000. If we assume no other money has been invested in the account, that represents a capital gain tax liability of $9,990,000.

But if that account owner dies, whoever inherits it will have a capital gain liability of $0. The basis in the account gets reset to the account value at the date of death, or a different value within 6 months of the original owner’s death. The step up in basis at death is one of the most favorable rules for American taxpayers and is exclusive to taxable accounts, like Individual TOD accounts, and real estate. This makes Individual TOD accounts excellent legacy planning tools.

If you own real estate, you know that you pay taxes on the property every year, similar to Individual TOD accounts. The nature of these taxes is different, though. Property taxes, aka ad valorem taxes, are levied by states and/or counties, not the IRS. In fact, for some people these taxes are deductible on the Federal level. If you hear someone talking about SALT deductions, they’re talking about State and Local Taxes that can be deducted, up to a limit, on Federal taxes.

But even though real estate and investment account tax rules are so different, they share two common traits: annual taxation and a step-up in basis at death. If someone inherits real estate and they choose to sell it, they will not owe taxes on any appreciation in the value of the property that has happened since it was first purchased.

It’s not uncommon for someone to live in a home for decades. This could mean a huge amount of capital gain relative to the property’s basis. But all of that gain gets erased at the death of the property owner when it passes to an heir. People who strongly believe in real estate as a means of creating generational wealth can point to the step-up in basis at death to justify their position.

IRA, 401k, and other retirement accounts are a different matter altogether. The SECURE Act, which went into law January 1, 2020, and SECURE Act 2.0, which went into effect January 2023, established new rules for how these accounts pass to beneficiaries.

IRAs, 401ks, and their like are considered Qualified accounts. The account owner gets tax deductions for making contributions, and the account grows tax deferred. The accounts “qualify” for current year tax benefits. But this means taxes will be due when money is withdrawn from the account. These accounts defer taxes, but do not eliminate them.

When the original account owner dies, these accounts receive no step-up in basis and will be fully taxable as ordinary income when they pass to a beneficiary. If the beneficiary is an adult child of the account owner, he or she will have 10 years starting the year after the account owner’s death to take all of the money out of the account. Any taxes due on those distributions will be the liability of the beneficiary.

For this reason, people who own large IRAs or other tax-deferred retirement accounts may consider strategies for reducing the tax burden their beneficiaries may face. During his or her lifetime, the account owner can convert the IRA into a Roth IRA. If you follow the rules, Roth IRAs hold after tax dollars, grow tax free, and avoid taxes on any account withdrawals. Life insurance proceeds – which are not taxable – can also help cover the cost of a big tax burden embedded in an inherited qualified account.

By paying the taxes on a Roth Conversion or using after tax dollars to pay life insurance premiums, the account owner assumes the liability for the taxes in the IRA. This allows beneficiaries to get an inheritance minus a tax headache. However, careful planning should be done prior to implementing this strategy to make sure the math makes sense. People can be so concerned about paying taxes that they implement strategies that are more expensive than the potential long term tax bill would have been.

Due to the complexities of converting retirement savings into income, many people often don’t start working with an advisor or planner until they are at or near retirement. However, people who are still decades away from claiming social security may find themselves in the midst of a complex inheritance situation. When this happens, it’s an excellent time to consult a professional who can help you understand the rules around an inherited account.

Meanwhile, people in the twilight of their lives who expect to pass money and property to their heirs need to monitor account beneficiary designations carefully and regularly. It may be necessary to draft a trust to handle complex beneficiary arrangements or to ensure that certain assets can avoid probate. As tax laws change frequently – as it did recently with the first and second SECURE Acts – having an advisor who can help you keep the rules straight may be worth the expense.

If you are confused and concerned about how to pass assets to your loved ones or a charity, or if you’ve inherited an account and are unsure what rules you need to follow, we’d love to help you. We help people of all ages make sense of their finances so that they have confidence and control over their wealth. If you’d like to schedule a complimentary consultation, please reach out.