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
We are in the midst of the greatest intergenerational transfer of wealth in history. Financial services research firm Cerulli Associates estimates that nearly 45 million U.S. households will transfer over $68 trillion in wealth over the next 25 years.
If you are the recipient of an inheritance, how should you adjust your financial plan? Our discussion below assumes the inheritance is not received from your spouse.
While everyone’s situation is different, it’s best not to adjust your financial planning on the expectation of receiving an inheritance. While it might seem likely that you will receive something from parents or perhaps other relatives, things can change over time. Families can have a falling out, or the person from whom you were expecting the inheritance might hit financial troubles that deplete their wealth.
It’s easy to overestimate the size of an expected inheritance as well. Data from the Federal Reserve indicates that about 50% of all inheritances amount to $50,000 or less. About 30% are in the $50,000 - $250,000 range. Roughly 2% of all inheritances are in excess of $1 million.
In all cases when a client receives an inheritance we help them look at how this money fits into their financial plan. This will depend upon the size of the inheritance and the state of their financial situation.
Regardless of the size of the inheritance, it makes sense to look for areas of your financial situation where the money can be best applied. These might include:
Depending upon the size and nature of the inheritance, one or more of these areas might be addressed with the inheritance.
The form in which the inheritance is received may dictate some planning on your part before you put the money to use. If the inheritance is received as cash, that’s pretty easy to deal with.
A cash inheritance might come in the form of a life insurance death benefit from a policy in which you were a beneficiary. Or you might inherit the balance in a bank account. However, this is not always the case.
Inheritances can come to heirs in a variety of ways. This can include securities such as shares of individual stocks, ETFs and mutual funds. It could take the form of real estate, art and collectibles or an interest in a privately held business.
The inheritance might come in the form of the deceased’s IRA or 401(k) account. With the advent of the SECURE Act at the beginning of 2020, the rules surrounding inherited IRA accounts for most non-spousal beneficiaries changed drastically. These beneficiaries are now required to withdraw the entire account balance within a ten year period.
Depending on the nature of the assets inherited, there may be tax or liquidity issues to deal with.
In the case of publicly traded securities, they can generally be sold any day the markets are open. With these assets, you may receive a step-up in basis, meaning that your cost basis will be the market value on the date of death, not the deceased’s original cost basis. In the case of highly appreciated stocks, ETFs or mutual funds this can save a huge amount in capital gains taxes if you sell the shares.
Real estate can also experience a step-up in basis in some cases as well. Assets like real estate, art, collectibles and others will not be as liquid as publicly traded securities. Besides the potential for a longer time horizon to sell these assets, they may or may not bring in the amount of money you are hoping for.
In the case of an interest in a privately held business, how you proceed will depend upon whether you are or would like to be involved in the business or whether you are looking to sell the business interest to other owners of the business or to an outside third party.
Taxes can also come into play in some cases. With the federal estate tax at $11.7 million for 2021, not many of our clients have to worry about this tax. However, there may estate taxes at the state level depending upon where you live.
Regardless of the size of the inheritance, it's important to make a plan for the money once it's available to you to use.
When we advise our clients on how to integrate money from an inheritance into their financial plan we look at a number of factors.
First we start with the size of the inheritance. If it is smaller, say in the $50,000 range, we might look at one or two targeted uses. This may be to help pay for their children’s college education, to pay off a debt or add to their investment portfolio.
For a larger inheritance, we suggest that clients focus on investing the major portion of this money for the longer-term. This often means incorporating this money into their investment strategy as part of their portfolio.
We may suggest using some to cover college costs for their kids or grandchildren. In some cases we may suggest using a portion to retire the remainder of their mortgage, especially if the client is nearing retirement.
We always want to be sure our clients have a sufficient emergency fund, so we may suggest that some of the inheritance be earmarked for this purpose.
Especially with a larger inheritance, it's OK to use some of it to buy something you want. Perhaps that’s a sports car. Maybe this is funding you need to take that around the world trip you’ve always dreamed of.
This type of expenditure is fine with a portion of the money, but overall we advocate that our clients incorporate the money from an inheritance into their financial plan to ensure they are able to achieve their goals, whether that’s retirement or something else.
If you are looking for a fee-only fiduciary financial advisor who will always put your interest first, please give us a call to discuss an inheritance or any other financial issues. We are here to help.
Bill Canty, CFP®, CPA
Maureen Walsh, EA, Investment Advisor Rep.
Ed Canty, CFP®
Tina Alteri, CPA, Tax Advisor
Joe Canty, Investment Advisor Rep.
