Understanding Inheritance Taxes: What You and Your Beneficiaries Need to Know

When considering your end-of-life plans, there’s a crucial aspect you might not have considered, yet it holds significant importance for your beneficiaries: will your loved ones face taxes on the inheritance you leave behind? The answer is not simple, as it largely hinges on the kinds of assets you are transferring, the total value of what you are passing on, and your place of residence at the time of your passing. Gaining insight into how various accounts and assets are taxed can empower you to make choices that lessen the tax impact on your heirs.

In this article, we will explore the tax consequences of different forms of inheritance, ranging from cash accounts to retirement plans, enabling you to plan wisely and safeguard more of your wealth for those you care about.

Estate Taxes: Will They Be Applicable?

There are three things we can never predict about you, regardless of how much preparation we undertake now and how diligent we are about your future planning: when you will pass away, what your assets will amount to at that time, and what the federal estate tax exemption will be at your time of death. Over the last 25 years, the federal estate tax exemption has varied from as low as $675,000 to as high as $15,000,000 per individual today.

This indicates that in 2026, the federal estate tax will only affect estates valued over $15 million for individuals or $30 million for married couples. If your estate is valued below this threshold, it will not incur federal estate taxes. However, if the value of your estate surpasses the exemption limit, taxes must be settled before beneficiaries can receive their shares. Additionally, if you are married, it is vital to review and update your estate planning after the first spouse’s passing to ensure the full estate tax exemption of the first spouse is utilized and preserved.

It’s important to recognize that certain states have their own estate or inheritance taxes, often with significantly lower exemption thresholds. To ensure thorough planning, it’s essential to grasp both federal and state regulations.

Additionally, keep in mind that estate tax, income tax, and capital gains tax are all relevant when discussing inheritance (trust taxes may also be applicable, but we will cover those in a future article for the sake of brevity). While you’re preparing for your passing, there are numerous factors to consider beyond just the federal or state estate tax. You should also devise a strategy for each asset type you possess.

With this understanding, let’s delve into how various asset types are taxed when your loved ones inherit from you.

Cash and Bank Accounts: The Straightforward Explanation

When your heirs inherit cash from checking, savings, or money market accounts, they benefit from favorable tax treatment. For instance, if you leave $50,000 in your savings account to someone, they will receive the entire $50,000 without facing federal income tax implications.

There is a minor exception to be aware of. If your account generates interest after your passing but before the funds are distributed, that interest will be considered taxable income for the beneficiary. Nevertheless, the principal amount itself remains exempt from taxes.

This simple treatment positions cash accounts as some of the most tax-efficient assets to inherit, which is why numerous estate plans incorporate liquid assets along with other investments.

Investment Accounts: The Step-Up in Basis Advantage

Taxable investment accounts, such as brokerage accounts that hold stocks, bonds, or mutual funds, take advantage of a feature known as a “step-up in basis.” This tax rule can save your beneficiaries a considerable amount of money.

Here’s how it functions. When you buy an investment, your “basis” is generally the price you paid for it. For instance, if you purchased stock for $10,000 and its value increased to $100,000, you would typically owe capital gains tax on that $90,000 gain if you sold it. However, when your beneficiaries inherit that stock, their basis “steps up” to the fair market value at the time of your death, which is $100,000 in this scenario. If they sell it right away for $100,000, they won’t owe any capital gains tax at all. Yet, if they sell it later and the stock has increased in value, they will be liable for capital gains tax – but only on the amount exceeding $100,000.

This step-up in basis represents one of the most significant tax advantages in estate planning, effectively eliminating all capital gains that accrued during your lifetime. Your beneficiaries are only responsible for capital gains tax on any appreciation that happens after they inherit the asset.

Grasping this advantage can shape your gifting approach. At times, it may be more tax-efficient to retain appreciated assets until death instead of gifting them while you’re alive, as the recipient would then inherit your lower basis and consequently face taxes on capital gains realized from a sale after receiving the asset.

Retirement Accounts: A More Intricate Scenario

Retirement accounts such as 401(k)s and traditional IRAs introduce more complex tax implications. Unlike other inherited assets, these accounts do not benefit from a step-up in basis and carry income tax responsibilities.

When your beneficiaries receive a traditional retirement account, they are required to pay ordinary income tax on any distributions. For instance, if you have $500,000 in your IRA and your daughter inherits it, she will be liable for income tax on every dollar she withdraws. The applicable tax rate will depend on her income bracket, making careful withdrawal planning crucial.

The SECURE Act of 2019, which was amended in 2022, brought about significant changes to the rules for most beneficiaries. In the past, non-spouse beneficiaries had the ability to “stretch” their distributions over their lifetime, which provided considerable tax advantages by keeping them in a lower tax bracket and allowing for tax deferral over a longer duration. However, now, in most situations, all retirement benefits must be distributed to beneficiaries (and taxed for income tax purposes) within 10 years following your death. This shortened timeline may result in beneficiaries being pushed into higher income tax brackets if they do not plan their withdrawals strategically.

On the other hand, spouses who inherit retirement accounts enjoy greater flexibility. They have the option to roll the inherited account into their own IRA, which permits them to delay distributions until they reach the age for required minimum distributions.

Roth IRAs present a unique benefit. Although beneficiaries are still subject to the 10-year distribution rule, qualified withdrawals from a Roth IRA are tax-free. If you have already paid taxes on your contributions to a Roth account, your beneficiaries will receive the funds without having to pay any income tax.

Life Insurance: Usually Tax-Exempt

Life insurance payouts are generally received by beneficiaries without any income tax, making them a fantastic tool for estate planning. For instance, if you hold a life insurance policy worth $1 million, your beneficiary will get the entire $1 million tax-free.

However, there is a significant consideration regarding estate taxes. If you are the owner of the policy on your own life, the death benefit might be counted as part of your taxable estate. In the case of very large estates, this could lead to estate taxes, even though the beneficiary won’t have to pay income tax. Utilizing advanced planning techniques, like irrevocable life insurance trusts, can help exclude life insurance from your taxable estate.

Strategic Planning Makes a Significant Impact

Grasping how various assets are taxed upon inheritance enables you to organize your estate with intention. You may opt to allocate tax-efficient assets such as cash or appreciated stocks to specific beneficiaries, while assigning retirement accounts to others who are better equipped to handle the tax implications.

We assist you in developing a Life & Legacy Plan that takes into account not only what you are leaving behind but also how to arrange your assets to reduce taxes and enhance what your loved ones will inherit. Tax regulations are subject to frequent changes, and your situation can shift over time, so having continuous, strategic advice is crucial for ensuring your plan is effective when your family needs it most. That’s where we step in.

Avoid leaving your beneficiaries to deal with unforeseen tax liabilities. Arrange a free 15-minute discovery call to find out how we can assist you.

Schedule a complimentary 15-minute consultation to learn more.

This article is a service of Kristen Wong of Seasons Estate Planning, APC, a Personal Family Lawyer® Firm. We don’t just draft documents; we ensure you make informed and empowered decisions about life and death, for yourself and the people you love. That’s why we offer a Life & Legacy Planning Session™, during which you will get more financially organized than you’ve ever been before and make all the best choices for the people you love. You can begin by calling our office today to schedule a Life & Legacy Planning Session™.

The content is sourced from Personal Family Lawyer® for use by Personal Family Lawyer® firms, a source believed to be providing accurate information. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking legal advice specific to your needs, such advice services must be obtained on your own separate from this educational material.