I recently received a question from someone asking about paying taxes on inherited money. This is not an uncommon question for our Ask the Advisor program. When someone passes away, talking about money may seem insensitive but unless you understand the financial and tax impact on inherited money, you may find yourself mourning more than the passing of your loved ones.
In this case a woman received $55,000 from her deceased father’s estate administrator after divvying up the cash held at her father’s bank between the surviving siblings. So the question was, will she need to pay tax on this money?
Based on the facts she presented, I say no. Assuming that all she inherited was cash from non-IRA accounts (which this sounds like), then the answer is no. But like everything else it’s not always that simple. There are three different levels of taxes to be concerned with here: income tax, federal estate tax and state estate or inheritance tax.
In the IRS code there is a provision regarding gifts and inheritances. On inherited assets of estates valued less than the federal limit (now about $5.3M), those who inherit property do not have any federal estate tax liability. Now, depending on the state, you may have to consider an estate or inheritance tax. If the state is “coupled” to the federal limits, then you would not owe any estate tax until the value of everything (home, cash, stocks, bonds) exceeded the federal limit. In some states like Massachusetts, the estate tax limit is different from the federal. At only $1 million, you may find that there may be a state “estate” tax that applies.
The same answer applies if a beneficiary received cash from a life insurance policy.
Now, if she had inherited something other than cash, she may have to deal with future tax issues. In this case, it’s all about the ‘basis’ of the asset received. So, let’s say that dad owned stocks that he bought many years ago for $10 per share. This is his “basis” in the stock – an accounting term for how much he paid including commissions. Now let’s assume he held those stocks for many years until he died. At that point, let’s assume that the stocks were trading at $50 per share. Even though there is a $40 per share gain, the person who inherits the stock will owe no income tax. The person who inherits the stock also receives a ‘step up in basis’ so that her basis for future tax computations will be based on the $50 per share price.
If the daughter in our example decides to sell these shares later when the market price is $60 per share, then she’ll only pay income tax on the difference between the prevailing market price ($60) and her stepped up basis ($50). This tax will be based on the more favorable and lower long-term capital gains rate. If she sells when the price is at $40 per share, she may have a $10 per share “loss.”
FYI: If she had inherited an IRA, then she would pay taxes on any distributions she receives based on her age (under 59 1/2 would be considered an early distribution). If this were an inherited IRA, then she would need to receive a distribution based on a specific schedule tied to her age and actuarial life expectancy.