Receiving an inheritance: the basics

An inheritance can arrive as cash, a house, an investment account, a retirement account, a life insurance payment or some mix of these. Each type follows its own rules for how it is transferred and how it is taxed. The few mistakes that cannot be undone mostly involve retirement accounts.

How inherited assets reach an heir

Assets pass in one of three main ways.

• By beneficiary designation. Retirement accounts, life insurance and accounts with a payable-on-death or transfer-on-death registration go directly to the person named on the form. The heir files a claim with the institution, usually with a death certificate.
• By joint ownership. Property held jointly with a right of survivorship generally passes to the surviving owner.
• Through the estate. Everything else passes under the will, or under state law if there is no will, usually through the court process called probate. This can take months or longer. See what probate is and how it works.

Is an inheritance taxable income?

For federal income tax, generally not. IRS Publication 525 states that in most cases property received as a gift, bequest or inheritance is not included in the recipient's income. Income the property produces afterward, such as interest, dividends or rent, is taxable to the new owner.

Two other taxes are sometimes confused with income tax.

• The federal estate tax is a tax on the estate of the person who died, and it applies only to estates above a large exemption amount. The IRS publishes the current figures on its estate tax page, and the post on federal estate and gift tax basics explains how it works.
• State taxes. Some states have their own estate tax or an inheritance tax paid by the recipient. State rules vary.

Life insurance proceeds paid because of the insured person's death are also generally not included in income, although any interest paid on them is taxable.

Inherited retirement accounts are different

Traditional IRAs and 401(k)s hold money that has never been taxed, and that tax bill passes to the beneficiary. The IRS states that beneficiaries must include taxable distributions in their gross income.

The timing of withdrawals is set by law. For deaths in 2020 or later, the IRS explains that most beneficiaries who are not the spouse must follow the 10-year rule: the entire account has to be emptied by the end of the tenth year after the year of the owner's death. Certain "eligible designated beneficiaries" have other options. These include a surviving spouse, a minor child of the account owner, a disabled or chronically ill person, and a person not more than 10 years younger than the owner.

Two practical points come from Publication 590-B:

• Someone who inherits a traditional IRA from anyone other than a spouse cannot treat it as their own, cannot contribute to it, and cannot roll it into their own IRA.
• The account can be moved to a different institution only by a trustee-to-trustee transfer into an IRA set up in the name of the deceased owner for the benefit of the beneficiary.

Taking the full balance at once is permitted, but it makes the whole taxable amount income in a single year, and a non-spouse beneficiary cannot reverse it.

Inherited Roth IRAs are generally subject to the same withdrawal timetable, but the IRS notes that withdrawals of contributions are tax-free and most withdrawals of earnings are too. The post on inherited IRAs covers the rules in detail.

Inherited investments and property: basis

When inherited stock, funds or real estate is later sold, any gain is measured from the asset's basis. The IRS explains that the basis of property inherited from a decedent is generally its fair market value on the date of death, or on an alternate valuation date if the executor files an estate tax return and elects it. This is often called a "step-up" in basis, although the adjustment can go down as well as up.

A hypothetical example: a parent bought shares many years ago for $20,000. On the date of the parent's death, the shares are worth $100,000. A child inherits them and later sells for $105,000. The child's taxable gain is $5,000, not $85,000. If the child sold for $95,000 instead, the result would be a $5,000 loss.

IRS Publication 551 covers special cases, such as jointly owned property, community property, and property the heir had given to the decedent within a year before death.

This rule does not apply to retirement accounts. Keeping a record of date-of-death values, such as a brokerage statement or an appraisal, makes a later sale easier to report.

Practical first steps

There is rarely a deadline that forces quick action on cash or investments. Items that do have a clock:

• Retirement accounts. The 10-year period and any annual required withdrawals begin with the year after death, and a required distribution the owner had not yet taken for the year of death still has to be withdrawn.
• Real estate. Insurance, property taxes and maintenance continue while the property is in the estate or in an heir's name.

Questions worth asking

• Which assets pass by beneficiary form, and which go through the estate?
• For each retirement account, which withdrawal rule applies to this beneficiary?
• Does the state impose an inheritance or estate tax?
• How does the inheritance fit with existing priorities, such as an emergency fund, debts or retirement savings?

State inheritance and probate laws vary and tax results depend on individual circumstances, so an attorney or tax professional can advise on the specifics of a particular estate.