Whether you pay tax on an inheritance depends on what type of asset you inherit. Here are some helpful answer on the tax impacts of your inheritance:

Cash 
Receiving cash, like funds from savings or checking accounts, are not taxable at the federal level. To avoid probate, be sure to add beneficiaries to your accounts.

Real Estate 
If you inherit property or assets, as opposed to cash, you generally don’t owe taxes until you sell those assets. These capital gains are calculated by using a stepped up basis. Meaning you only owe taxes on any appreciation that happens after you inherit the property. 

Retirement Accounts
These accounts are among the most income tax-sensitive assets to inherit. They’re usually funded with pre-tax dollars, so you’ll likely owe income tax on distributions. There are also rules regarding the amount and timing of these distributions. Failure to comply with these rules can result in steep penalties (50%). 

Roth IRA and Roth 401(K)
Unlike traditional 401(k)s and IRA, Roth accounts are funded with after tax dollars. These accounts have similar rules around distributions, but the withdrawals are tax free. 

Taxable Investment Accounts
When you inherit these assets, you have the option to sell them right away or keep them for potential growth. For taxable investments, the stepped-up basis applies. For instance, if you inherit ABC stock bought at $10, now worth $30, you won’t owe taxes on gains if you sell it for $30 due to the stepped-up basis. But remember, future dividends, interest, or capital gains are usually subject to taxes.

Trusts
Assets can also be distributed through trusts, rather than directly inheriting them. If you’re a beneficiary of a trust, the trust documents will outline how and when these assets will be distributed. The specific provisions and tax implications of a trust vary from case to case, so effective communication with the trustee and consultation with your legal and tax professionals are crucial.

Life Insurance
Generally, life insurance proceeds received as a beneficiary are not subject to income tax. Proper planning can often eliminate estate taxes as well.

Federal and State Taxes
Depending on your inheritance size, there could be estate and/or inheritance taxes. The key distinction between estate tax and inheritance tax is who pays the tax. Estate taxes are based on the assets of the deceased, prior to any distributions to beneficiaries. Another key difference is that inheritance taxes only apply to the specific assets that are inherited rather than the decedent’s entire estate. 

At the federal level, only a small fraction of estates actually pay any estate tax. The estate’s value must exceed $12.92 million per person (as of 2023) for taxation to apply. For estates over this threshold, the estate tax rate is anywhere from 18% – 40%. However, it’s worth noting that this exemption will be cut in half in 2026 unless Congress intervenes

It is possible to be taxed at both the federal and state level. Twelve states and the District of Columbia impose estate taxes (Illinois, New York, Oregon, Washington, Maryland, Connecticut, Vermont, Rhode Island, Maine, Massachusetts, and Hawaii). Other states like Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania, impose an inheritance tax. There is only one state who imposes both and that is Maryland. 

In Illinois, you pay taxes on the entire estate if it is above the $4 million threshold. The estate tax rate is graduated and the top rate is 16%. 

Bottom Line
Before making any decisions to sell assets or property, it’s crucial to have a discussion with a financial advisor and a tax accountant. They can help you assess the potential tax implications of the sale and guide you on how to make the most of your newly acquired wealth. If you have additional questions or concerns about these delicate matters, don’t hesitate to get in touch with us. We are here to assist and support you in your financial journey.

George Maroudas, CFP®

George Maroudas, CFP®

847-550-6100
george@pmgwealth.com
Twitter @ChicagoAdvisor

Disclaimers:

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice.