Generally, the inherited principal — whether it's money, property, or other assets — is not considered taxable income to the recipient at the federal level. However, income generated by inherited assets is taxable to the person who inherits them.
Understanding Federal Taxability of Inherited Assets
When you inherit money or property, the inheritance itself is typically not subject to federal income tax for the beneficiary. This means if you inherit $100,000 in cash, that $100,000 is not reported as income on your federal tax return.
The U.S. federal government imposes an estate tax on the transfer of assets from a deceased person's estate to their beneficiaries, but this tax is levied on the estate itself, not on the individual inheritor. For 2024, the federal estate tax exemption is quite high ($13.61 million per individual), meaning only very large estates are subject to this tax. Even when estate tax applies, it's paid by the estate before assets are distributed, so beneficiaries generally receive their inheritance free of this direct tax liability.
When Inherited Assets Generate Taxable Income
While the initial inherited amount might not be taxed, any income the inherited assets produce after you receive them is taxable. This is a crucial distinction. For example:
- Interest: If you inherit a savings account or certificate of deposit (CD) that earns interest, any interest earned after the date of inheritance is taxable income to you.
- Dividends: Inherited stocks, mutual funds, or exchange-traded funds (ETFs) that pay dividends will generate taxable dividend income for you.
- Rents: If you inherit a rental property, the rental income collected from that property is taxable income to you, subject to deductions for expenses.
- Capital Gains: If you inherit property (like real estate, stocks, or other investments) and then sell it for a profit, that profit (capital gain) is generally taxable. The cost basis for inherited property is typically "stepped up" to its fair market value on the date of the deceased's death, which can significantly reduce or eliminate capital gains tax if you sell it soon after inheriting it.
Specific Inherited Assets with Tax Implications
Certain types of inherited assets have unique tax rules because they represent pre-tax money or untaxed gains:
- Inherited Retirement Accounts (IRAs, 401(k)s, etc.):
- Traditional Accounts: If you inherit a traditional IRA, 401(k), or similar pre-tax retirement account, the distributions you take are generally taxable as ordinary income. The original owner contributed to these accounts with pre-tax dollars, and the earnings grew tax-deferred. You will need to take distributions according to specific IRS rules (e.g., the 10-year rule for many non-spouse beneficiaries).
- Roth Accounts: Inherited Roth IRAs and Roth 401(k)s are generally tax-free to the beneficiary, provided the account has been open for at least five years and the distributions are qualified.
- Inherited Annuities: If you inherit an annuity, the portion of the payout that represents untaxed earnings (the difference between the amount paid into the annuity by the original owner and the value at the time of death) is typically taxable as ordinary income when distributed.
- Inherited Savings Bonds: If you inherit U.S. savings bonds (e.g., Series EE or I bonds), the accrued interest that was not previously taxed is taxable when you redeem the bonds. You can choose to report the interest annually or defer it until redemption.
State-Level Inheritance or Estate Taxes
Beyond federal taxes, it's important to be aware of state laws. While most states do not have an inheritance tax, some do.
- State Inheritance Tax: This tax is levied on the beneficiaries who receive inherited property, and the rates can vary based on your relationship to the deceased. As of 2024, states with an inheritance tax include Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
- State Estate Tax: Similar to the federal estate tax, this tax is levied on the deceased person's estate before assets are distributed. A number of states impose their own estate tax, often with lower exemption thresholds than the federal tax.
Summary of Taxability
The following table provides a quick overview of how common inherited assets are generally treated for federal income tax purposes for the beneficiary:
| Type of Inherited Asset | Federal Income Tax for Beneficiary | Notes |
|---|---|---|
| Cash, Real Estate, Personal Property | Generally Not Taxable | Income generated after inheritance (e.g., rent, interest) is taxable. |
| Stocks, Bonds, Mutual Funds | Generally Not Taxable | Dividends, interest, and capital gains from sales are taxable. |
| Traditional IRA/401(k) | Taxable as Ordinary Income | Distributions are taxed; subject to withdrawal rules. |
| Roth IRA/401(k) | Generally Tax-Free | Distributions are tax-free if qualified. |
| Annuities | Gain Portion is Taxable | Earnings are taxed as ordinary income upon distribution. |
| U.S. Savings Bonds | Accrued Interest is Taxable | Untaxed accrued interest is taxed upon redemption. |
Practical Advice
- Keep Records: Maintain detailed records of inherited assets, including their fair market value on the date of the deceased's death (the "step-up in basis"). This information is crucial for calculating future capital gains.
- Consult a Professional: Inheritance tax laws can be complex, especially with retirement accounts or multi-state assets. It's advisable to consult with a tax advisor or estate planner to understand your specific obligations and optimize your tax situation.
