Inheriting an investment account can significantly impact your financial situation, but it also comes with important tax considerations. Whether you’ve inherited a regular brokerage account, an IRA/401(k), Roth IRA, or a trust, understanding the tax implications is crucial for managing your newfound wealth effectively. This article will guide you through the key tax issues related to these types of accounts, including stepped-up basis, required minimum distributions (RMDs), and other factors that could affect your financial planning.
When you inherit a regular brokerage account, such as one holding stocks, bonds, ETFs, or mutual funds, one of the most significant tax advantages is the "stepped-up basis." The stepped-up basis allows you to reset the cost basis of the inherited assets to their fair market value at the date of the decedent’s death. This can substantially reduce the capital gains tax you would owe if you decide to sell the assets.
Example: If your benefactor bought a stock for $10 per share and it’s worth $50 per share at their death, your cost basis is "stepped up" to $50. If you sell the stock at $55, you’ll only owe capital gains tax on the $5 increase, rather than the $45 increase from the original purchase price.
However, this benefit applies only to assets in taxable accounts. If the value of the assets increases after the date of death, those gains will be taxable when you sell the assets. Additionally, any dividends or interest earned after the decedent's death will be taxable as income to you.
If inherited assets are transferred to your name from another financial institution, it's essential to make sure that the cost basis is updated. Correcting this ensures you don't pay unnecessary capital gains taxes when selling the assets, preserving more of your inheritance.
Inheriting a traditional IRA or 401(k) involves a different set of rules, primarily because these accounts typically consist of pre-tax contributions. This means that any distributions you take will be subject to ordinary income tax.
RMDs: If you inherit an IRA or 401(k) from someone who was already taking required minimum distributions (RMDs), you must continue taking RMDs based on your life expectancy or follow the 10-year rule, which requires you to deplete the account within 10 years of the original account holder's death. If the account owner had not yet reached the age for RMDs, you generally have more flexibility but still need to comply with distribution rules within the 10-year timeframe.
Roth IRAs: Inheriting a Roth IRA is more advantageous from a tax perspective. Since contributions to Roth IRAs are made with after-tax dollars, distributions are generally tax-free as long as the account has been open for at least five years. You still need to follow the 10-year rule for depleting the account, but you won’t face the same tax burden as with a traditional IRA.
Spousal Inheritance: If you inherit an IRA or 401(k) from a spouse, you have additional options. You can treat the account as your own, either by rolling it into your own IRA or by remaining the beneficiary and taking distributions according to your life expectancy. This allows for greater flexibility and can provide more control over the tax impact.
Trusts are often used to manage and distribute assets according to the grantor’s wishes, offering both tax advantages and protections for beneficiaries. When you inherit a trust, the tax implications will depend on the type of trust:
Revocable Trusts: Also known as living trusts, these are still considered part of the grantor’s estate and are subject to estate taxes. Upon the grantor’s death, the trust assets receive a stepped-up basis similar to regular brokerage accounts. Distributions to beneficiaries are typically not taxed directly, but are instead tied to the trust’s income and capital gains.
Irrevocable Trusts: With an irrevocable trust, the assets are removed from the grantor’s estate, which can help reduce estate taxes. However, the tax treatment of distributions depends on whether the trust retains the income or distributes it to beneficiaries. Beneficiaries who receive distributions will generally pay income tax on the income generated by the trust, rather than on the distributions themselves.
Special Considerations: Trusts can also be subject to high tax rates on undistributed income, so it’s often advantageous to distribute income to beneficiaries, who may be in lower tax brackets. Additionally, trusts can have complex rules regarding how assets are managed and distributed, so it’s essential to work closely with your financial advisor and your attorney to understand the implications fully.
Inheriting investment accounts can significantly affect your financial future, but it’s essential to navigate the tax implications carefully. Understanding the differences between regular brokerage accounts, IRAs/401(k)s, and trusts, and how each is taxed, can help you make informed decisions that align with your financial goals. Working with a financial advisor who has an expertise in tax can provide invaluable guidance, ensuring that you maximize the benefits of your inheritance.
Thank you for reading,
The Canty Financial Team
Bill Canty, CFP®, CPA, Financial Planner
Ed Canty, CFP®, Financial Planner
Joe Canty, CFP®, Financial Planner
Tina Alteri, CPA, Tax Advisor
Maureen Walsh, EA, Tax Advisor
