How Does Inheriting Money Impact Your Income Taxes?
How does inheriting money impact your income taxes? It is a common question. We will look at retirement accounts, Roth IRAs, and other types of assets.
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How Does Inheriting Money Impact Your Income Taxes?
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How does inheriting money impact your income taxes?
Inheriting money does not create a direct income tax liability. But the assets that you receive could. There are two primary types of assets, retirement accounts and everything else.
Retirement accounts include IRAs, 401ks, and a TSA from a non-profit employer. There are different rules for spouse and non-spouse beneficiaries.
If you are a spouse and inherit the account, you get to treat that account as if it was your own. You must take required minimum distributions at age 72. (there is pending legislation to increase that to age 75.) If the account is a traditional IRA, the income from that account is taxed as ordinary income. Roth IRAs have different rules. Distributions might be tax-free. (More on this below)
If you are a non-spouse beneficiary, different guidelines apply. The new rules state you must liquidate that account within ten years. We are waiting for guidance from the IRS to know if annual distributions are required. Some believe the annual distributions are not required.
Distributions from a traditional IRA or 401k get taxed as ordinary income. Here is a simple example. You inherit an IRA account worth $250,000. To spread the distributions evenly over the next 10 years, you must take $25,000 per year from that account. This $25,000 gets added to your other income. If you are still working, this could create a tax headache. Remember, tax rates for ordinary income are higher than capital gains.
There are non-retirement assets. This includes a primary residence, an individual, or a joint account. This can create some taxable income in a couple different ways.
Sometimes those investments pay income distributions. It could be rent from a rental property. Some investments, like stocks, pay dividends. Other items like savings accounts or bonds pay interest. Those income streams are taxable to you as the new owner.
The other way income taxes factor into this is when you sell those assets. This is where cost basis comes into play.
In most cases, cost basis is what you pay for an asset. There can be adjustments to the cost basis over a person’s lifetime. For example, you may make improvements to your home. This increases your basis. You may reinvest dividends on a stock, which also increases your cost basis.
Cost basis changes when a person dies owning an asset. Under current law, the cost basis of those assets gets stepped up or down to the value on the date of death.
Your parents paid $50,000 for their home. But when they die, it is worth $250,000. Your basis when you inherit it is $250,000.
Your parents bought stock in the XYZ company for $25, but at their death, it was worth $10. Your cost basis is $10. But you do not have any tax impact until you sell the asset.
Take the example of shares of fictional company XYZ. Your mom paid $4 per share for that position several years ago. Over time it increased in value and when she passed away it was worth $10 a share. Your new cost basis is $10. If you sell that for $12 per share, you have a capital gain of $2 a share. However, if you sell that asset for $8 a share because it decreased in value after she passed away, you have a capital loss of $2 per share.
Roth IRA Tax Rules
Distributions from Roth IRA’s might be tax-free, but certain rules apply. The Roth IRA account has to have been open for at least five years. If the account was opened two years ago, your distributions will not be completely tax-free until the five-year period is over.
The second rule applies to Roth conversions. Each conversion has its own 5-year time frame. Even if the account has been open more than five years, you could still owe some income taxes on distributions. If there was a conversion done in 2019, the amount that converted is not tax free until 2024. Any amounts converted in 2020 would not be tax free until 2025 when that five-year window has passed.
You need to be careful if you inherit a Roth IRA. Make sure you understand what is taxable and what is not.
Less Common Situations
There are less common situations, such as inheriting assets from an irrevocable trust. If you inherit assets from an irrevocable trust, you might not benefit from the step-up in cost basis. If this applies to you, check with the attorney and the advisor who helped set up those documents.
Potential Tax Changes
There are some potential tax changes on the horizon. There is the possibility of legislation that would eliminate the step-up in cost basis. There is also a proposed bill which creates what is called a “deemed sale at death.” This means the tax code would treat those assets as being sold on the date of the owner’s death. This creates a capital gain tax liability. Neither of those bills has passed, yet, and they may not pass. It is something we continue to watch.
Talk to a Certified Financial Planner™ Professional
This can be a complicated topic when you get into specifics. If you have a question about your situation, contact a financial planner to help you with the details. If you would like to talk to us, pick a date and time on the calendar below.
About the Author
Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors. He specializes in helping hard working, middle class families plan for retirement.