Many clients ask about the taxability of inherited assets. Generally, funds or assets you inherit are not taxable; if estate taxes (sometimes referred to as death taxes) are due they are paid by the estate prior to distribution to beneficiaries. A few states (not Michigan) have an inheritance tax. The rules regarding how to treat inherited assets for tax purposes are very complicated and I will only cover a few topics in the space permitted.
There are several situations where you “inherit” a tax liability. The situation we see most often is an Inherited IRA (i.e., IRA, SEP, Simple IRA) or other retirement account (i.e., 401(k), 403(b)). When you inherit a Traditional IRA, withdrawals from the IRA are taxable as ordinary income to you the beneficiary. If the beneficiary is the spouse of the deceased they have the option of rolling over the IRA and treating it as their own; it is not subject to required distributions until they reach 70 ½.
However, if you inherit an IRA or other retirement account and you are not the spouse of the deceased you are immediately required, following the year of death, to take distributions based on your life expectancy. You are not limited to taking the minimum, but you must take the minimum distribution or there are heavy penalties. There is not a 10% penalty for withdrawing from an Inherited IRA before turning 59 ½. You also may opt for the 5 Year Method that requires you withdraw the entire account value within five years of death; you may wait until the 5th year before taking any withdrawals. Regardless of your method, any withdrawal from an Inherited IRA is taxable as ordinary income.
Many who inherit stocks, mutual funds, ETFs, bonds, or real estate are not aware how to determine their cost basis and acquisition date of the property. First, when these types of properties are inherited, the acquisition date (date of death) is immaterial in determining long term or short tem holding period. If you inherit property, you are considered to have held it more than a year – long-term. The cost basis, in most cases, is “stepped-up” to the value on the date of death. The value for securities (stocks, ETFs, bonds) is the average of the high and low of the date of death; mutual funds is the closing price of the day; real estate is also stepped up to the market value at the date of death.
The discussion above is very general and situations often arise where the rules above are not applicable: previously stepped-up basis; annuities; Roth 401(k)s and IRAs; alternate date of death valuations, etc.
All comments and suggestions are welcome.
Suzanne M. Antonelli, CFP®