What Happens When You Inherit an Already Inherited IRA?
When you are the successor beneficiary of an Inherited IRA the rules are very complex.
When someone passes away and they have a retirement account, if there are non-spouse beneficiaries listed on the account, they will typically rollover the balance in the inherited retirement account to either an Inherited Traditional IRA or Inherited Roth IRA. But what happens when the original beneficiary passes away and there is still a balance remaining in that inherited IRA account? The answer is that a successor beneficiary inherits the account, and then the distribution rules become complex very quickly.
Beneficiary of an Inherited IRA (Successor Beneficiaries)
As a beneficiary of an inherited IRA, it's important to understand that the options available to you for taking distributions for the account will be determined by the distribution options that were available to the original beneficiary of the retirement account that you inherited it from, which vary from beneficiary to beneficiary.
Non-spouse Inherited IRA Rule
The IRS changed the rules for non-spouse beneficiaries back in 2019 with the passing of the Secure Act, which put original non-spouse beneficiaries in two camps: beneficiaries that inherited a retirement account from someone that passed away prior to January 1, 2020, and beneficiaries that inherited retirement accounts some someone that passed January 1, 2020 or later.
We have a whole article dedicated to these new non-spouse beneficiary rules that can be found on our website but for now I will move forward with the cliff notes version.
Stretch Rule vs 10-Year Rule Beneficiaries
As the beneficiary of an inherited IRA, you must be able to answer two questions:
Was the original beneficiary subject to the “RMD stretch rule” or “10-year rule”?
If that beneficiary was required to take an RMD in the year they passed, did they already distribute the full amount?
Original Beneficiary was the Spouse
A common situation is that a child has two parents - the first parent passes away, and the balance in those retirement accounts are then inherited by the surviving spouse and moved into the surviving spouse’s own retirement accounts. A spouse of an original owner of a retirement account has special rules available to them which allow them to roll their deceased spouse’s retirement accounts into their own retirement accounts and treat them as their own. When their children inherited the remaining balance in the retirement accounts from the second to parent, they are considered non spouse beneficiaries and are most likely subject to the new 10-year distribution rule unless they qualify for an exception.
Non-spouse Beneficiary 10-Year Rule
If the original beneficiary of the Inherited IRA received that account from someone that passed away after December 31, 2019 and they are a non-spouse beneficiary, they are most likely subject to the new 10-Year Rule which requires the original beneficiary to fully deplete that retirement within 10 year of the year following the original decedent’s death.
Example: Sue, the original owner of a Traditional IRA passes away in 2022, and her daughter Katie is the sole beneficiary of her IRA. Since Katie is a non-spouse beneficiary, she would be required to fully deplete the IRA by 2032, 10 years following the year after that Sue passed away.
But what happens if Katie, the original beneficiary of that inherited IRA passes away in 2026, and she is only 4 years into the 10-year depletion cycle? In this example, when Katie set up her inherited IRA, she named her two children Scott & Mara as 50/50 beneficiary on her inherited IRA account. Scott and Mara would move their respective 50% balance into their own inherited IRA account but as beneficiaries of an already inherited IRA, the 10-year rule does not reset. Scott & Mara would be bound to the same 10-year depletion date that Katie was subject to so Scott & Mara would have to deplete the Inherited IRA (2 times inherited) by 2032 which was Katie’s original 10-year depletion date.
10-Year Rule: The basic rule is if the original beneficiary of the inherited IRA was subject to the 10-year rule, as the new beneficiary of that existing inherited IRA, you get whatever time is remaining in that original 10-year period to fully deplete that Inherited IRA. It does not matter whether the inherited IRA that you inherited was a Traditional IRA or a Roth IRA, the same rules apply.
Original Beneficiary was a “Stretch Rule” beneficiary or the Spouse
For original non-spouse beneficiaries that inherited the retirement account from an account owner that passed away before January 1st, 2020, they have access to what is called the Stretch Rule. Those non-spouse beneficiaries are allowed to move the original owners balance of the retirement account to their own inherited IRA and they are not required to deplete the account in 10 years.
Instead, those non-spouse beneficiaries are only required to take an annual RMD (required minimum distribution) each year, which are small distributions from the Inherited IRA each year, but they could effectively stretch the existence of that inherited account over their lifetime. But it’s also important to note, that some non-spouse beneficiaries that inherited a retirement account from someone who passes on or after January 1, 2020, may have qualified for a stretch rule exception which are as follows:
Surviving spouse
Person less than 10 years younger than the decedent
Minor children
Disabled person
Chronically ill person
Some See-Through Trusts benefitting someone on this exception list
If the original beneficiary of the inherited IRA was eligible for the stretch rule, and you inherited that inherited IRA from that individual, you would NOT be eligible for the Stretch Rule, you would be subject to the 10-year rule, but you would have a full 10-years after the owner of that inherited IRA passes away to fully deplete the balance in that inherited IRA that you inherited.
When we are talking about beneficiaries of an already inherited IRA, it does not matter whether you were their spouse or non-spouse because the spouse exceptions only apply to the spouse of the original decedent.
Example: John inherited a Traditional IRA from his father who passed away in 2018. John was a non-spouse beneficiary, but since his father passed before 2020, he was eligible for the stretch provision which allowed John to roll over the Traditional IRA to an inherited IRA in his name and he was only required to take annual RMD’s each year but was not required to deplete the account in 10 years. John passes in 2025, his daughter Sarah is the beneficiary of the Inherited IRA, since Sarah inherited the inherited IRA from John who passes after December 31, 2019, Sarah would be required to deplete the balance in John’s inherited IRA by 2035, 10-year following the year after John passes.
RMD of Beneficiaries of Inherited IRAs
Now we have to move on to the second question that beneficiaries of Inherited IRAs need to ask, which is “does the successor beneficiary of an inherited IRA need to take annual RMD’s from the account each year?” The answer is “it depends”.
It’s common for beneficiaries of Inherited IRAs to be subject to both the 10-year rule and be required to take annual required minimum distributions from the account. Whether or not the beneficiary needs to take an RMD will depend on the whether or not the original beneficiary of the account was required to take RMDs. The basic rule is if the current owner of the Inherited IRA was required to take annual RMD’s from the account, you as the beneficiary of the Inherited will be required to continue to take RMD’s from the account. The IRS has a rule that once an owner of an IRA or Inherited IRA has started taking RMDs, they cannot be stopped.
If the answer is “Yes:”, the person that you inherited the Inherited IRA from was already taking RMD’s from the Inherited IRA account, then you as the beneficiary of that inherited IRA would be subject to whatever time is left in the 10-year rule, and you would also be required to take RMDs from the account each year.
Don’t Forget To Take The Decedent’s RMD
RMD’s are usually required to begin the year after an individual passes away which is true of Inherited IRAs but as the beneficiary of an retirement account, where the decedent was required to take an RMD for that year, you have to ask the question: did they satisfy their RMD requirement before they passed away.
If the answer is “yes”, no action is required in the year that they passed away unless they were in year 10 year of the depletion cycle.
If the answer is “no”, then you as the beneficiary of that existing Inherited IRA are required to take the undistributed RMD amount from that inherited IRA in the year that the decedent passed away.
Example: Kelly inherits an Inherited IRA from her mother Linda. Linda originally inherited the IRA from her father when he passed in 2022. At the time that her father passed, he was 80, which made him subject to RMDs. When Linda inherited the account from her father, since he was subject to RMDs, Linda was subject to the 10-year rule and annual RMDs. Linda passed in 2024, her daughter Kelly inherits her Inherited IRA, and Kelly would be required to fully deplete the inherited IRA by 2032 (Linda original 10 year rule date), she would be required to take annual RMD’s from the account because Linda was receiving RMDs, and if Linda did not receive her full RMD in 2024 when she passed, Kelly would have to distribute any amount that Linda would have been required to take in the year that she passes.
A lot of rules, but all very important to avoid the IRS penalties that await the taxpayers that fail to take the proper RMD amount or fail to adhere to the new 10-year rule.
Summary of 3 Successor IRA Questions
When you are the beneficiary of an inherited IRA, you must be able to answer the following questions:
Was the person that you inherited the inherited IRA from subject to the 10-year rule?
Was the person that you inherited the Inherited IRA from required to take annual RMDs?
Did the decedent take their RMD before they passed?
What was the age of the decedent when that passed?
The last question is important because there are potential situations where someone is the original beneficiary of an Inherited IRA subject to the 10-year rule, based on the age of the original owner when they passed and the age when the original beneficiary when they inherited the IRA may not make them subject to the annual RMD requirement. However, if the original beneficiary passes away after their “Required Beginning Date” for RMDs, the beneficiary of that inherited IRA may be subject to an annual RMD requirements even though the original beneficiary was not.
The IRS has unfortunately made the rules very complex for beneficiaries of an Inherited IRA account, so I would strongly recommend consulting with a professional to make sure you fully understand the rules.
General Rules Successor IRA Rules
If you are a successor beneficiary:
If the owner on the inherited IRA was subject to the stretch rule, you as the successor beneficiary are now subject to the 10-year rule
If the owner of the Inherited IRA was subject to the 10-year rule, you have whatever time is remaining within that original 10 year window to deplete the account balance.
Whether or not you have to take an RMD in the year they pass and in future years, is more complex, seek help from a professional.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Don’t Gift Your House To Your Children
A common financial mistake that I see people make when attempting to protect their house from a long-term care event is gifting their house to their children. While you may be successful at protecting the house from a Medicaid spend-down situation, you will also inadvertently be handing your children a huge tax liability after you pass away. A tax liability, that with proper planning, could be avoided entirely.
A common financial mistake that I see people make when attempting to protect their house from a long-term care event is gifting their house to their children. While you may be successful at protecting the house from a Medicaid spend-down situation, you will also inadvertently be handing your children a huge tax liability after you pass away. A tax liability, that with proper planning, could be avoided entirely.
Asset Protection Strategy
As individuals enter their retirement years, they become rightfully more concerned about a long-term care event happening at some point in the future. The most recent statistic that I saw stated that “someone turning age 65 today has almost a 70% chance of needing some type of long-term care services at some point in the future” (Source: longtermcare.gov).
Long-term care is expensive, and most states require you to spend down your countable assets until you reach a level where Medicaid starts to pick up the tab. Different states have different rules about the spend-down process. However, there are ways to protect your assets from this Medicaid spend-down process.
In New York, the primary residence is not subject to the spend-down process but Medicaid can place a lien against your estate, so after you pass, they force your beneficiaries to sell the house, so Medicaid can recoup the money that they paid for your long-term care expenses. Since most people would prefer to avoid this situation and have their house passed to their children, they we'll sometimes gift the house to their kids while they're still alive to get it out of their name.
5 Year Look Back Rule
Gifting your house to your kids may be an effective way to protect the primary residence from a Medicaid lien, but this has to be done well before the long-term care event. In New York, Medicaid has a 5-year look back, which means anything that was gifted away 5 years before applying for Medicaid is back on the table for the spend down and Medicaid estate lien. However, if you gift your house to your kids more than 5 years before applying for Medicaid, the house is completely protected.
Tax Gifting Rules
So what’s the problem with this strategy? Answer, taxes. When you gift someone a house, they inherit your cost basis in the property. If you purchased your house 30 years ago for $100,000, you gift it to your children, and then they sell the house after you pass for $500,000; they will have to pay tax on the $400,000 gain in the value of the house. It would be taxed at a long-term capital gains rate, but for someone living in New York, tax liability might be 15% federal plus 7% state tax, resulting in a total tax rate of 22%. Some quick math:
$400,000 gain x 22% Tax Rate = $88,000 Tax Liability
Medicaid Trust Solution
Good news: there is a way to altogether avoid this tax liability to your beneficiaries AND protect your house from a long-term care event by setting up a Grantor Irrevocable Trust (Medicaid Trust) to own your house. With this solution, you establish an Irrevocable Trust to own your house, you gift your house to your trust just like you would gift it to your kids, but when you pass away, your house receives a “step-up in cost basis” prior to it passing to your children. A step-up in cost basis means the cost basis of that asset steps up the asset’s value on the day you pass away.
From the earlier example, you bought your house 30 years ago for $100,000, and you gift it to your Irrevocable Trust; when you pass away, the house is worth $500,000. Since a Grantor Irrevocable Trust owned your house, it passes through your estate, receives a step-up to $500,000, and your children can sell the house the next day and have ZERO tax liability.
The Cost of Setting Up A Medicaid Trust
So why doesn’t every one set up a Medicaid Trust to own their house? Sometimes people are scared away by the cost of setting up the trust. Setting up the trust could cost between $2,000 - $10,000 depending on the trust and estate attorney that you engage to set up your trust. Even though there is a cost to setting up the trust, I always compare that to the cost of not setting up your trust and leaving your beneficiaries with that huge tax liability. In the example we looked at earlier, paying the $3,000 to set up the trust would have saved the kids from having to pay $88,000 in taxes when they sold the house after you passed.
Preserves $500,000 Primary Residence Exclusion
By gifting your house to a grantor irrevocable trust instead of your children, you also preserve the long-term capital gain exclusion allowance if you decide to sell your house at some point in the future. When you sell your primary residence, you are allowed to exclude the following gain from taxation depending on your filing status:
Single Filer: $250,000
Joint Filer: $500,000
If you gift your house to your children and then five years from now, you decide to sell your house for whatever reason while you are still alive, it would trigger a tax event for your kids because they technically own your house, and it’s not their primary residence. By having your house owned by your Grantor Irrevocable Trust, if you were to sell your house, you would be eligible for the primary residence gain exclusion, and the trust could either buy your next house or you could deposit the proceeds to a trust account so the assets never leave the trust and remain protected for the 5-year lookback rule.
How Do Medicaid Trusts Work?
This article was meant to highlight the pitfall of gifting your house to your kids; however, if you would like to learn more about the Medicaid Trust solution and the Medicaid spend down process, please feel free to watch our videos on these topics below:
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
A CFP® Explains: Wills, Health Proxy, Power of Attorney, & Trusts
When we are constructing financial plans for clients, we inevitably get to the estate planning portion of the plan, and ask them “Do you have updated wills, a health proxy, and a power of attorney in place?
When we are constructing financial plans for clients, we inevitably get to the estate planning portion of the plan, and ask them “Do you have updated wills, a health proxy, and a power of attorney in place?” The most common responses that we receive are:
“I know we should have but we never did”
“I did but it was over 10 years ago”
“I have a will but not a health proxy or a power of attorney”
“I have heard about trusts, should I have one?”
The Will, Health Proxy, and Power of Attorney are the three main estate documents that most people should have. In this article I will review:
How Wills work and items that you should include in your Will
Why you should have a Health Proxy and how they work
Power of Attorney
The probate process
Considering a testamentary trust
Assets that pass outside of the Will
Revocable Trusts & Irrevocable Trusts
Estate planning tips
How much does it cost to establish a will, health proxy, and a power of attorney
Establishing A Will
The most basic estate document that most people are aware of is a written Will. The Will provides specific guidance as to who will receive your assets after you have passed away. The Will also establishes who would be the guardian of your minor children should you pass away prior to your children reaching the age of majority. Without a Will, state laws and the court system that know nothing about you, will decide who receives your assets and who will be the guardian of your minor children; not a situation that most people want.
The Will can be a very simple document. If you are married and have children, the Will may state that if you pass away everything goes to your spouse but if both you and your spouse were to pass away simultaneously, the assets go to the children. For individuals or married couples without children, or for married couples that have been divorced, it’s also critical to have a Will to provide direction as to what will happen to your assets if you were to pass away.
You can engage an estate attorney to complete a simple Will or if your Will is very simple and straightforward, you may elect to use a do-it-yourself option through a platform like Legal Zoom. We typically encourage clients to meet with an estate attorney because when it comes to estate planning many people don’t know what questions to ask to get the right documents and plan in place. If you are married with minor children, and you and your spouse were to pass away leaving all the assets to the kids, with a simple Will, they would have access to their full inheritance at age 18. An 18 year old having access to large sums of money may not be an optimal situation. In those cases, you may want to include a testamentary trust or revocable trust in your estate plan to put some restrictions in place as to how and when your children will have access to their inheritance.
Probate
I'm going pause here for a moment and explain what probate is and the probate process. When someone passes away, all of the assets included in their estate go through what's called a “probate process”. The probate process is a legal process of accounting for all of your assets, debts, and transferring your assets to the beneficiaries of your estate. The person listed in your will as the “executor” is responsible for coordinating the probate process. Depending on the size of the estate, your executor will usually work with an attorney, an accountant, and possibly appraiser, to:
Value the assets in your estate
Work with the courts to process your estate
Pay outstanding expenses or debts
Coordinate the transfer of assets to your beneficiaries
Since the probate process is a legal process involving the courts, the process often takes longer than beneficiaries expect. Individuals will make the incorrect assumption that when you pass away, they just read the will, and your beneficiaries receive the assets within a few days or weeks; unfortunately that's not that case. It’s not uncommon for the probate process to take 6 to 12 months and there are expenses involved with probating an estate. If it’s a complex estate, it could take over a year to complete the probate process.
For these reasons, it’s a common goal with estate planning to find ways to avoid the probate process and pass you assets directly to your beneficiaries. I will explain more about these strategies later on. But circling back to our discussion about the Will, if all you have is a Will, when you pass away, the assets in your estate will pass through this probate process.
Testamentary Trusts
There are a lot of different types of trusts within in estate planning world. One of the most basic and common trusts, especially for individuals with children under that age of 25, is a testamentary trust. A testamentary trust is a trust that is built into your will. With at testamentary trust, you are not establishing a trust today , but rather, if you pass away, a trust is established during the probate process and you can direct assets to the trust. Building a testamentary trust into your Will gives you some control over how the assets are distributed to the beneficiaries after you have passed away.
It's common for individuals or married couples with children under that age of 25, to build these testamentary trusts into their Wills. I will illustrate how these trusts work in the example below.
Example: Jim and Sarah have two children, Rob age 14 and Wendy age 8. Between the value of their house, life insurance policies, and other assets, their estate would total $1.5M. Jim & Sarah realize that if something were to happen to them tomorrow, they would not want their kids to inherit $1.5M when they turn age 18 because they might not go to college, they may try to start a business that fails, buy a Corvette, etc. In their Will they establish a Testamentary Trust that states that if both parents pass away prior to the children turning age 25, all of their assets will flow into a trust, and that Sarah’s brother Harold will serve as the trustee. Harold as the trustee is able to distribute cash from the trust for living expenses, education, health expenses, and other expenses deemed necessary for the well being of the children. The children will receive 1/3 of their inheritance at age 25, 30, and 35.
You can design these testamentary trusts however you would like. In the Will you would designate who will be the trustee of your trust and the terms of the trust.
IMPORTANT NOTE: Testamentary trusts do not avoid probate like other trusts do. The trust is established as part of the probate process.
Revocable Trusts & Irrevocable Trusts
It's also common for individuals and married couples to consider establishing either a Revocable Trust or Irrevocable Trust as part of their estate planning. These are separate from Testamentary Trusts. Revocable Trusts and Irrevocable Trusts are being established today and assets owned by the trust pass in accordance with the terms set forth in the trust document. There are material differences between these two types of trusts but some primary reasons why people establish these types of trust are to:
Avoid probate
Protecting assets from a long term event
Control how and when assets are distributed beyond the date of death
Reducing the size of the estate
Advanced tax strategies
Assets That Pass Outside of The Will
There are certain assets that pass outside of the Will. Many of these “other assets” pass by “contract”, meaning there are beneficiaries designated on those accounts. A common example of assets that pass by contract are 401(k) accounts, IRA’s, annuities, and life insurance. When you set up those accounts you typically designate beneficiaries for each account and your Will could say something completely different. The assets that pass by contract do not have to go through the probate process unless the beneficiary listed on the account is your estate which is usually not an advantageous election for most individuals.
Transfer On Death Accounts (TOD)
One of the estate planning strategies that we use with clients is instead of holding an individual investment account in the name of the individual, we will register the account as a “transfer on death” (TOD) account. If you have an individual brokerage account and you pass away, the value of that account will have to go through probate. By simply adding the TOD feature to an existing individual brokerage account which lists beneficiaries similar to a 401(K) or IRA account, that account now avoids probate, and passes by contract directly to the beneficiaries.
Depending on the assets that make up your estate, you may be able to setup TOD accounts as opposed to going through the process of setting up trusts but it varies from person to person.
Power of Attorney
Let’s shift gears now over to the Power of Attorney document. A Power of Attorney document is important because it allows someone to step into your shoes and handle your financial affairs, should you become incapacitated. Some common examples are:
Example 1: If you're in a car accident and end up in a coma, for accounts that are held only in your name, such as a checking account, investment account, or credit card, they will only speak to you. Being married does not give your spouse access financially to those accounts while you are still alive but your spouse may need access to them to continue to pay your bills or get access to cash to pay expenses while you're incapacitated. Having a power of attorney document would allow your spouse or trusted individual named as your “agent” to act financially on your behalf.
Example 2: Having a power of attorney in place is key for Long Term Care events. If you have a spouse or parent and they have a stroke, develop dementia, or another health event that renders them unable to handle their personal finances, you could step in as their agent and handle their personal finances. In long term care situations that can often mean paying a nursing home, applying for Medicaid, paying medical bills, or shifting the ownership of assets to protect from a Medicaid spend down.
The Power of Attorney can also be built so your agent is not given that power today but rather it would only be given if a triggering event happened sometime in the future. With this document you really have to name someone you 100% trust. As financial planners, we have seen cases where there is abuse of the Power of Attorney powers and it’s never pretty. It's not uncommon for a power of attorney to allow the agent to make gifts as a planning tool, but that might also include gifts to themselves, so you have to fully trust your agent and the powers that you provide to them.
Health Proxy
The health proxy is usually the least fun estate document to complete but is equally important. In this document you are naming the individual that has the right to make your health decisions for you if you are incapacitated. This document spells out what you want and don’t want to have happen if certain health events occur. While it's not uncommon for individuals to be a little uncomfortable completing this document due to the nature of the questions, it's a lot better to complete it now, versus your family members trying to determine what your wishes would be when a severe health event has already occurred.
The health proxy will list items like:
Would you be willing to be put on life support?
If you could not eat, would you allow them to use a feeding tub
Resuscitation preferences
Willingness to accept blood transfusions
Again, not fun things to think about but by you making these decisions while you are of sound body and mind, it takes away the difficult situation where your family members have to decide in the heat of the moment what you would have wanted. That situation can sometimes tear families apart.
Keep Your Estate Plan Up To Date
All too often, we run into this situation where a client will acknowledge that they have estate documents, but they were established 20 years ago, and they never made any changes. It makes sense to meet with your estate attorney and revisit your estate plan:
Every five years
If you move to a different state
When Congress makes major changes to the estate tax rules
The estate laws vary state by state. If we have clients that are planning to move and they plan to change their state of domicile to another state, we will often encourage them to meet with an estate attorney within that state once the move is complete. Congress has also made a number of changes to the federal estate tax laws over the past few years, with potentially more in the works, and not revisiting the estate plan could end up costing your beneficiaries tens of thousands of dollars in estate taxes that could have been avoided with some advanced planning.
Cost of Estate Documents
The cost of establishing a Will, Health Proxy, Power of Attorney, and Trusts, often varies based on the complexity of your estate plan. A simple Will may cost less than $1,000 to establish through an estate attorney. Establishing all three documents: Will, Health Proxy, and Power of Attorney may cost somewhere between $1,000 - $3,000. While it's not uncommon for individuals to be surprised by the cost of setting up these estate documents, I always urge people to think about the cost of not having those documents in place. The probate process with professionals involved could cost thousands of dollar, your beneficiaries could lose thousands of dollars in taxes that could have been avoided, not to mention the emotional toll on your family trying to figure out what you would have wanted without clear guidance from your estate documents. Revocable Trusts and Irrevocable Trust
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Do I Have To Pay Taxes On My Inheritance?
Whenever people come into large sums of money, such as inheritance, the first question is “how much will I be taxed on this money”? Believe it or not, money you receive from an inheritance is likely not taxable income to you.
Whenever people come into large sums of money, such as inheritance, the first question is “how much will I be taxed on this money”? Believe it or not, money you receive from an inheritance is likely not taxable income to you.
Of course there are some caveats to this. If the inherited money is from an estate, there is a chance the money received was already taxed at the estate level. The current federal estate exclusion is $5,430,000 (estate taxes and the exclusion amount varies for states). Therefore, if the estate was large enough, a portion of the inheritance may have been subject to estate tax which is 40% in most cases. That being said, whether the money was or was not taxed at the estate level, you as an individual do not have to pay income taxes on the money.
Although the inheritance itself is not taxable, you may end up paying taxes if there is appreciation after the money is inherited. The type of account and distribution will dictate how the income will be taxed.
Basis Of Inherited Property
Typically, the basis of inherited property is the fair market value of the property on the date of the decedent’s death or the fair market value of the property on the alternate valuation date if the estate uses the alternate valuation date for valuing assets. An estate will choose to value assets on an alternate date subsequent to the date of death if certain assets, such as stocks, have depreciated since the date of death and the estate would pay less tax using the alternate date.
What the fair market value basis means is that if you inherit stock that was originally purchased for $500 and at the date of death has appreciated to $10,000, you will have a “step-up” basis of $10,000. If you turn around and sell the stock for $11,000, you will have a $1,000 gain and if you sell the stock for $9,000, you will have a $1,000 loss.
Inheriting a personal residence also provides for a step-up in basis but the gain or loss may be treated differently. If no one lives in the inherited home after the date of death, it will be treated similar to the stock example above. If you move into the home after death, any subsequent sale at a loss will not be deductible as it will be treated as your personal asset but a gain would have to be recognized and possibly taxed. If you rent the property subsequent to inheritance, it could be treated as a trade or business which would be treated differently for tax purposes.
Inheriting An IRA or Retirement Plan Account
Please read our article “Inherited IRA’s: How Do They Work” for a more detailed explanation of the three different types of distribution options.
When you inherit a retirement account, and you are not the spouse of the decedent, in most cases you will only have one option, fully distribute the account balance 10 years following the year of the decedents death. The SECURE Act that was passed in December 2019 dramatically change the distribution options available to non-spouse beneficiaries. See the article below:
If you are the spouse of the of the decedent, you are able to treat the retirement account as if it was yours and not be forced to take one of the options above. You will have to pay taxes on distributions but you do not have to start withdrawing funds immediately unless there are required minimum distributions needed.
Note: If the inherited account was an after tax account (i.e. Roth), the inheritor must choose one of the options presented above but no tax will be paid on distributions.
Non-Qualified Annuities
Non-qualified annuities are an exception to the step-up in basis rule. The non-spousal inheritor of a non-qualified annuity will have to take either a lump sum or receive payments over a specified time period. If the inheritor chooses a lump sum, the portion that represents the gain (lump sum balance minus decedent’s contributions) will be taxed as ordinary income. If the inheritor chooses a series of payments, distributions will be treated as last in, first out. Last in, first out means that the appreciation will be distributed first and fully taxable until there is only basis left.
If the spouse inherits the annuity, they most likely have the option to treat the annuity contract as if they were the original owner.
This article concentrated on inheritance at a federal level. There is no inheritance tax at a federal level but some states do have an inheritance tax and therefore meeting with a professional is recommended. New York currently does not have an inheritance tax.
About Rob……...
Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.
