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4 Ways to Protect Your Inheritance

Updated for Tax Year 2022 • December 1, 2022 09:10 AM


OVERVIEW

Received an inheritance of cash, investments, or property? Here are four ways that can help you keep it from being swallowed up by taxes.


For information on the third coronavirus relief package, please visit our “American Rescue Plan: What Does it Mean for You and a Third Stimulus Check” blog post.


 

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Protecting your inheritance from taxes

Inheritances are not considered income for federal tax purposes, whether you inherit cash, investments or property.  However, any subsequent earnings on the inherited assets are taxable, unless it comes from a tax-free source. You will have to include the interest income from inherited cash and dividends on inherited stocks or mutual funds in your reported income. For example:

  • 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.

Consider the alternate valuation date

Typically the cost 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 often 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.

Put everything into a trust

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 that wills typically have to go through.

  • With a revocable trust, the grantor can take the assets out if necessary.
  • An irrevocable trust usually 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 can actually increase the taxes the child pays.

  • When joint owner dies, the other owner already owns a portion of of the assets. This means that there is a step up in cost basis on the portion that is inherited but not on the rest of the account.
  • For long-held assets, this can mean a significant tax hit when the child sells the asset.

Minimize retirement account distributions

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

  • If one spouse dies, the surviving spouse usually can take over the IRA as their own. Required minimum distributions would typically begin at age 72, just as they would for the surviving spouse's own retirement accounts.
  • If you inherit a traditional IRA from someone other than your spouse, you can transfer the funds to an inherited IRA in your name. You can then decide on a distribution method:
    • based on your life expectancy
    • take the money out all at once by the end of the year after the account holder died
    • if the decedent was under age 72 then you also have the option to take out all of the money within 10 years after the year that the account holder died.

Give away some of the money

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 avoid taxable gains on appreciated property and receive a tax deduction by 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—$16,000 for 2022—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.

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