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What Did You Inherit?
When a client calls to let me know they received an inheritance, the question on their mind is whether their inheritance is taxable. I usually tell them that they've asked a good question, but I need more information before I can answer it.
Before it can be determined what part, if any, of an inheritance must be claimed on your income tax return, you must first know the origins of what you are receiving.
There are many kinds of property and investments that you may inherit. Typical items might be a house, life insurance proceeds, savings accounts, checking accounts, stocks, rental properties, household goods and furniture, collectibles, vehicles, IRA or 401(k) accounts, and a variety of other items which may or may not have a monetary value.
Your inheritance may be paid through the estate’s attorney, from a trust, by an individual who is informally handling the affairs of the estate, or it may be paid directly to you because you were a named beneficiary (Note: a beneficiary is the person who receives the inheritance), or even because you were listed as a joint owner on the title of the property.
It is also important to make the distinction between federal estate or state inheritance taxes and income taxes. Estate and state inheritance taxes are paid based on the value of the property and investments that are owned on the date of death and should be paid by the estate before your inheritance is distributed to you. You might still owe federal and state income taxes on property distributed to you from the estate, even if the estate and/or inheritance taxes have already been paid.
With that bit of background, we can more easily answer the question of whether a specific inheritance will be taxable.
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Virtually all regular life insurance proceeds are non-taxable when paid directly to the individual beneficiary or beneficiaries (rather than directly to an estate or a business) named on the policy. If the life insurance is not immediately paid out and interest is earned and/or the payments are higher than the date of death benefit, then the interest or amount that is greater than the date of death benefit is claimed as income on your taxes.
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Savings Accounts, Checking Accounts, Stocks, Bonds, Most “Regular" Investments
If you receive an inheritance of the funds in a regular bank account, such as a savings account, the value of the account on the date of death will be non-taxable. Any interest earned from the data of death to the date that you receive the money will be taxable income. This is the same for stocks, bonds, mutual funds and other regular investments. Any dividends, stock dividends, or other earnings after the date of death will be taxable to you.
When you sell inherited stocks, bonds, mutual funds, or other investments, then unless the date of death was in 2010, you will calculate your gain or loss based on the value of the investment on the date of death. For most property inherited in 2010, the basis will be the decedent’s (Note: the decedent is the person who died) cost, instead of the date of death value.
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IRA Accounts, 401(k) Accounts, Pensions, and Annuities
If the type of inheritance you received was an IRA, 401(k), 403(b) plan, 457 account, pension, annuity, or other type of tax-deferred or retirement-type of account, then proceed with caution. You will pay tax on all or most of this inheritance, with few exceptions." You will need to refer to the decedent’s prior tax returns and/or contact the administrator of the retirement account to determine the non-taxable part, if any, of an inherited IRA, 401(k), pension, annuity, or other tax-deferred account.
The inherited retirement account will not be taxable to you until you withdraw the money from the account. Therefore you will have some control over when you will have to claim the inheritance on your taxes.
I’ll present some general information on these types of inheritances, but be cautioned that each account should be individually examined for specific tax laws, the taxable amount should be individually calculated, and withdrawals carefully planned for maximum tax savings.
If you inherit the retirement account from your spouse, you may be able to roll over the account into your own retirement account and treat it with the same rules as your own account. You may also be able to re-name the inherited account and treat it with the same or similar rules as your deceased spouse.
Non-spouses may be able to roll the money over into a special type of Inherited IRA account. To defer taxes, it may not be rolled over into your own existing regular IRA account and you may not receive a check directly, even if you immediately deposit the check into the special Inherited IRA.
You must begin taking required minimum distributions from an Inherited IRA by Dec 31 of the year following the decedent’s death. Otherwise, you will be required to withdraw all of the funds by the end of the fifth year after the decedent’s death. In this case, you can take as much or as little as you want in each of the five years, as long as balance in the account is zero at the end of the fifth year.
Non-spouses may also have the option of rolling inherited non-IRA retirement accounts into an Inherited Retirement Account. The terms of the original plan and the IRS code will then determine when you must take withdrawals from the plan.
For inherited ROTH IRA accounts, if the five year waiting period for the ROTH IRA account has already passed, then withdrawals of your inheritance from these types of accounts should be tax-free.
With any of the inherited retirement plans, you should also have the option to immediately withdraw all of the funds in a lump sum and then claim this inheritance on your taxes in full (less any basis of the decedent) in the year you withdrew it.
Yes, it’s a little complicated. Since the amounts inherited in IRA’s, 401(k)’s, 403(b) plans, 457 accounts, annuities, and other retirement-type accounts tend to be fairly large, you are well advised to consult with a CPA or tax accountant who will help you determine the best timing and amounts to withdraw from these accounts.
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Checks Received from an Estate Administrator or a Trust
When you receive your inheritance in the form of a check from an estate checking account or a trust checking account, then again we will need more information to determine how much, if any, of the check will have to be claimed on your taxes. In this case, the only way to determine if there will be taxable income to claim is to get the information from the administrator or trustee.
During the time period that the decedent’s property and investments are held by the estate or trust, the estate or trust will earn interest, dividends, rents, or other types of income. When the estate or trust sells property or investments, taxable gains or losses will occur. The administrator or trustee will be responsible for having a fiduciary tax return (usually a Form 1041) prepared if the income amounts require it. Any income tax owing may be paid by the estate or trust or the income may instaed be distributed out to the beneficiaries and reported on a Form K-1. If you receive this Form K-1 from the estate or trust, then you will report the amounts from the K-1 on your personal tax return.
The administrator or trustee may also advise you that no tax return, and therefore no K-1 was needed and that you will not have to claim any of the amount of the check you received as income on your tax return.
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Paychecks, Rents, Pension Checks, Other Similar Funds
If you directly receive any paychecks, rent checks, pension checks, or other amounts that the decedent would have received as taxable income if he had not died, then this is usually taxable income to you and you should claim this on your tax return as ordinary “income in respect of a decedent." Note that if there is a formal estate opened, then usually these types of checks are turned over to the estate and any tax is determined as in the section above for estates and trusts.
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Household Goods, Furniture, Vehicles
These types of inheritances generally do not need to be claimed on your tax return. It's usually quite safe to assume that you can relax in your inherited recliner and watch your inherited TV without concern for paying income taxes on either one.
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While this article is a general overview, the following will offer more specific information on your type on inheritance and whether you have to claim it on your taxes:
IRS Publication 525 - refer to the section on Life Insurance Proceeds - http://www.irs.gov/publications/p525/ar02.html#en_US_2010_publink1000229373
IRS Publication 575 - refer to the section on Survivors and Beneficiaries http://www.irs.gov/pub/irs-pdf/p575.pdf%20
IRS Publication 559 - Survivors, Executors, and Administrators http://www.irs.gov/pub/irs-pdf/p559.pdf
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This article is not intended to be specific tax advice. It is intended as a general guideline only. Any specific advice should be sought from your tax professional.
CIRCULAR 230 DISCLOSURE: Pursuant to Treasury Department guidelines, any federal tax information contained in this article, or any attachment, does not constitute a formal tax opinion. Accordingly, any federal tax advice contained in this communication, or any attachment, is not intended or written to be used, and cannot be used, by you or any other recipient for the purpose of avoiding penalties
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