The good news for people who inherit money or other property is that they don't have to pay income tax on it. This comes as a happy surprise to many inheritors.
An inheritance can be a windfall in many ways—the inheritor not only gets cash or a piece of property, but doesn’t have to pay income tax on it. Someone who inherits a $500,000 bank account doesn’t have to pay any tax on that amount.
It doesn’t matter how the property passes to the inheritor. Whether the property passes under the terms of a will or trust, or the inheritor was a designated beneficiary (for example, a payable-on-death bank account), it’s not taxable income.
There’s always an exception to the rule. In this case, it concerns funds in retirement accounts, which may be taxed when they’re withdrawn by inheritors. It depends on the kind of account.
The money contributed to conventional IRAs and 401(k) plans is generally not taxed before it is put in. Either contributions are made with pre-tax dollars, or the contributor gets a tax deduction for the contribution. Income tax on the funds is deferred until money is withdrawn from the account, either by the original contributor or by the person who inherits the account.
A beneficiary who withdraws money from an inherited account must report that money as ordinary income. The tax will be due with the person’s regular annual income tax returns (state and federal).
If some contributions were nondeductible, then the beneficiary doesn’t have to pay tax on them. Figuring out just what portion of the funds isn’t taxable, however, can be complicated. The beneficiary will probably need some expert help.
Surviving spouses who inherit a retirement account can defer the tax by rolling over the account into a retirement account of their own (here's more on that). Other beneficiaries can change the account into an “inherited IRA” and withdraw the money over several years, spreading out the income tax as well.
Money that a beneficiary withdraws from a Roth IRA or 401(k) plan, however, is generally not taxable income. Roth accounts are funded with money that has already been taxed, so the accounts are treated like other inherited property.
People don’t have to pay income tax on amounts they take from a Roth account they inherited if:
For more on this, see Inheriting Retirement Accounts: Legal Overview.
Once a beneficiary owns an asset, any income produced by that asset is taxable income. For example, if you inherit a house and rent it out to tenants, you must pay income tax on the rent payments you receive. Similarly, if you inherit a bank account, you don’t pay income tax on the funds in the account; but if they start earning interest, the interest payments are your taxable income.