Received an inheritance of cash, investments, or property? Here are four ways that can help you keep it from being swallowed up by taxes.
The federal tax filing deadline for individuals has been extended to May 17, 2021. Quarterly estimated tax payments are still due on April 15, 2021. For additional questions and the latest information on the tax deadline change, visit our “IRS Announced Federal Tax Filing and Payment Deadline Extension” blog post.
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.
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 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.
- 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 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.
Minimize retirement account distributions
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 one spouse dies, the surviving spouse usually can take over the IRA as their own. Required minimum distributions would begin at age 72, just as they would for the surviving spouse's own IRA.
- If you inherit a retirement account from someone other than your spouse, you can transfer the funds to an inherited IRA in your name. You must begin taking minimum distributions the year of or the year after the inheritance, even if you're not 72 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.
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 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—$15,000 for 2020—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.