4 Ways to Protect Your Inheritance from Taxes

Inheritances are not considered income for federal tax purposes, whether you inherit cash, investments or property.  Any subsequent earnings on the inherited assets are taxable, however. You will be taxed on the interest paid on inherited cash in a bank account, for example, or dividends on inherited stocks or mutual funds.

Any gains when you sell inherited investments or property are generally taxable, but you can usually also claim losses on these sales. State taxes on inheritances vary; check your state's department of revenue, treasury or taxation for details, or contact a tax professional.

Typically the basis of property in a decedent’s estate is the fair market value of the property on the date of death. In some cases, however, the executor might choose the alternate valuation date, which is six months after the date of death. The alternate valuation is only available if it will decrease both the gross amount of the estate and the estate tax liability; this will result in a larger inheritance to the beneficiaries. Any property disposed of or sold within that six-month period is valued on the date of the sale. If the estate is not subject to estate tax, then the valuation date is the date of death.

If you are expecting an inheritance from parents or other family members, suggest they set up a trust to deal with their assets. A trust allows you to pass assets to beneficiaries after your death without having to go through probate. Trusts are similar to wills, but trusts generally avoid state probate requirements and the associated expenses.

"Use a revocable trust, which means that the grantor can take the money out at any time if necessary," advises Warren. An irrevocable trust ties up the assets until the grantor dies. It may be tempting for parents to put their assets into joint names with a child, but this will actually increase the taxes the child pays. When an account holder dies, the joint holder inherits not only the assets, but also the basis, which is used to figure the asset's taxable gain in value over the years. For long-held assets, this can mean a significant tax hit when the child sells the asset.

Inherited retirement assets are not taxable until they’re distributed. Certain rules may apply to when the distributions must occur, however, if the beneficiary is not a spouse.

"If the husband dies,” Warren notes, “the wife can step into his shoes and take over the IRA as her own." Required minimum distributions would begin at age 70 1/2, just as they would for the spouse's own IRA.

If you inherit a retirement account from someone other than your spouse, you can transfer the funds to an IRA in your name. You must begin taking minimum distributions the year of or the year after the inheritance, even if you're not 70 1/2 yet. If you are younger than the decedent, consider electing the "single life" method of calculating the required distribution amount, based on your age. Your minimum distributions will be smaller, which means you'll pay less tax on them and the money can grow, tax deferred, for a longer period of time.

It may seem counter-intuitive, but sometimes it makes sense to give a portion of your inheritance to others. In addition to helping those in need, you could potentially offset the taxable gains on your inheritance with the tax deduction you receive for donating to a charitable organization.

If you're expecting to leave money to people when you die, consider giving annual gifts to your beneficiaries while you're still living. You can give a certain amount to each person -- $14,000 for 2013 -- without being subject to gift taxes. Gifting not only provides an immediate benefit to your loved ones, it also reduces the size of your estate, which can be important if you're close to the taxable amount. Talk with an estate planning professional to ensure you're staying current with the frequent changes to estate tax laws.