The good news for people who inherit money or other property is that they usually 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 In this case, it concerns funds in retirement accounts, which may be taxed when they're withdrawn by inheritors. Whether an inherited account is taxable depends on the kind of account.
The money contributed to traditional 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 Income tax on the funds is deferred until money is withdrawn from the account, either by the original contributor or by the person who inherits the account.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 (both state and federal).
Surviving spouses who inherit a retirement account can defer the tax by rolling over the account into a retirement account of their own. Other beneficiaries can change the account into an "inherited IRA" and withdraw the money over several years, spreading out the income tax as well, but, with a few exceptions, they must withdraw the full amount in the account within ten years.
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.
Whether a beneficiary has to pay tax on the proceeds of a life insurance policy depends on whether the proceeds are paid in a lump sum or in installments with interest. If they are paid in a lump sum, they are not taxed. If they are paid in installments over several years, the part of each installment that constitutes interest (rather than principal) is taxable income each year.
If you inherit property that appreciates in value, the amount of the gain is also taxable. To calculate exactly how much the property has gained in value, you'll need to determine what's called the "basis" in the property. Typically, for tax purposes, the basis would simply be how much you originally paid for the property. However, when you inherit property, you get the benefit of what's called a "stepped-up basis," which means that instead of being taxed on the entire gain from the moment of the deceased person's purchase, you're taxed only on the gain from the deceased person's date of death.
Example: In 2020, Miko inherited her mother's house, whose fair market value on the date of her mother's death was $500,000. Miko's mother had purchased the house in 1990 for $200,000. In 2021, Miko sells the house for $550,000. Because her basis is "stepped up" to $500,000, Miko owes capital gains tax only on a gain of $50,000.
For more information, see Capital Gains Tax on Inherited Property.
If you live in Iowa, Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania, note that you might also owe an inheritance tax—separate from income tax—on the property you inherit. How much tax you owe depends on your relationship to the deceased; surviving spouses generally pay nothing, and children pay either nothing or very low tax rates. The tax rate typically increases the more distantly related you are.