Did grandma leave you something in her will to help you buy a house or pay for school? While that type of windfall is a blessing, you also might also be wondering “do I claim inheritance on my taxes?”. Understanding what you’ve received and where taxes fit in could help you save thousands of dollars. This article covers those different account types and gives tips on how to save taxes on your inheritance.
First the good news! Most bank accounts only hold cash, and cash received as an inheritance is not actually taxed. This is because cash does not grow in value, and the IRS has excluded cash inheritances from being taxed. However, there are six states that have state-level inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
Retirement accounts, on the other hand, are taxed when distributions are made from the inherited retirement account. The distribution is taxed at your ordinary income tax rate.
The government also mandates inherited retirement accounts to make distributions over time. These distributions are known as Required Minimum Distributions (RMDs), and the distribution schedule is based on the relationship you have to the deceased. In general, the rules are as follows:
This is a simplification of the overall tax rules, but knowing this information can help you plan accordingly in reducing your overall income tax. In fact, here are five tips to consider when taking RMDs from your inherited retirement accounts.
Perhaps grandma built up a nest egg in a non-retirement account and then bequeathed it to you in her will. When you sell those investments, the gain from those investments will be taxed at the capital gains rate, which is normally 15 to 20%.
However, there’s actually a strategy that you’ll want to take advantage of, called the step-up in cost basis, to reduce your taxes. This is a rule in the tax code that allows you to update the initial purchase price of the investments to a value based on the decedent’s date of death.
Here is how a step up in cost basis can help you save on taxes. Often, inherited assets have been purchased many years ago. By stepping up an inherited investment’s cost basis, realized gains are reduced. This in turn decreases your corresponding taxes on the gain.
For example, one of our clients purchased a stock for a few thousand dollars more than 40 years ago. That stock is now worth more than a million dollars! When our client passes away, a step up in cost basis will change the realized gain for her children and grandchildren from being over $900,000 to something a lot less (e.g. tens of thousand dollars). At a 15 or 20% tax rate, this could be over $150,000 in savings just for updating some data.
However, it’s important to know that a step up in cost basis does not necessarily happen automatically. And for some accounts, such as inherited assets that were in joint accounts, you might have to go out of your way to update your cost basis. If you don’t, the IRS will be more than happy to use the original cost basis when levying a tax on any sale proceeds.
So here are three things to do in order to update your cost basis for an inherited investment.
Knowing these tips and the difference between the type of accounts and assets you’ve inherited, whether it be in cash, retirement, or non-retirement accounts, can help you save taxes on inherited assets.
For more questions or more specific financial planning situations connect with a member of the Prudent Investors team.
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