Don’t spend it all at once: no matter how big or small your inheritance is, learn about the tax consequences, before you begin enjoying or investing any funds.
Depending on what kind of asset you inherit, you may have no taxes, a whopping tax bill, or something in-between. If you inherit a retirement account like an IRA or a 401(k), you’ll want to be especially careful, says U.S. News & World Report in the article, “Tax-Savvy Ways to Manage an Inheritance.” Making a mistake with these accounts could consume a huge amount of your inheritance.
IRAs or 401(k)s. If a deceased relative, spouse, or friend passes along an IRA or employer retirement savings account, you should understand how it will be taxed. The options for the account are based on your relationship to the deceased person. A spouse may be able to roll the funds into their own account. That’s an option that other beneficiaries don't have. A spouse can also open an Inherited or Beneficiary IRA account. This account has both partners' names on it. A young spouse can withdraw funds, without getting hit with the 10% early withdrawal penalty.
Other heirs of the benefactor, such as a child, nephew, niece, or grandchild, don't have the option to deposit the money in their own retirement account. However, they can hold it in an Inherited IRA account. Once they decide how to deposit the money, the rate at which spouses and other heirs decide to withdraw the funds can have significant tax implications. If they decide to take out all the money in a lump sum, they may experience a "double whammy" tax bill. That’s because for a traditional IRA, the lump sum would be treated as taxable income. Beneficiaries could pay roughly 40% in taxes if they live in a state that charges income tax. It also could push them into a higher tax bracket, causing them to pay more taxes on their regular income.
The better move for heirs is to spread out the distributions over their lifetime. This is often called a "stretch IRA," because it allows investors to stretch out the time during which earnings can grow.
The specific rules regarding how beneficiaries manage Inherited IRAs are determined by whether the deceased person was older than 70½ at the time of death. Generally, heirs who want to keep their tax bill as low possible, must take required minimum distributions (RMDs), based on their life expectancy, within about a year of inheriting the account. They won't see the 10% early withdrawal penalty, but they'll be taxed on the amount they take out. However, the RMDs will generally be smaller than a lump sum and less apt to push them into a higher tax bracket. Recipients who want to take minimum distributions, must take the first one before the required date, or they may be forced to liquidate the account within five years.
Inherited Roth IRAs have already been taxed and don’t have the same tax burden. However, that’s not a good reason to immediately withdraw a lump sum. As long as you take RMDs, IRA funds can stay in the account and grow tax-free.
Stocks or Mutual Funds. An inheritance may also consist of investments outside of a retirement account, like individual stocks or mutual funds. Remember the "step-up basis," which is important to reduce taxes on the sale of these investments. When the owner dies, regardless what they paid for that stock or mutual fund, the cost basis “steps up” to whatever the price of that stock or fund was at the date of death. For example, if a grandfather bought IBM stock for $5 per share, and when he dies, it's worth $100. The heir's basis is the stock’s value when he died, rather than the price at which he bought the stock years earlier. It’s a critical difference when it comes to how heirs calculate and pay capital gains taxes, upon the sale of an asset.
Remember that these assets may have to go through probate. Assets like mutual funds and houses that don’t have a beneficiary designated, may go through probate. This can be avoided with proper planning in advance.
Real Estate. Similar to stocks and mutual funds, an inherited house enjoys a step-up basis. For tax purposes, the cost basis is what the market value was when the benefactor died. Try to have the home appraised immediately after the benefactor's death, to gain an understanding of what the basis is now. If it's not being passed along to a spouse, an inherited house will usually need to go through probate.
Life Insurance. Life insurance is tax-free, but you still need to do good financial planning when deciding how to invest the life insurance payout.
Cold, Hard Cash. While a cash inheritance is not taxable from a federal tax standpoint, there may be state tax implications, depending upon the state where you reside.
Whatever the kind of asset you inherit, it would be wise to meet with an estate planning attorney to take care of two objectives at once: determine what kind of a tax situation has been created by the inheritance, and start working on your estate plan. You may now have assets that you need to protect, and that’s best done through an estate plan.
Reference: U.S. News & World Report (October 18, 2018) “Tax-Savvy Ways to Manage an Inheritance”