Did grandma leave you something in her will to help you buy a house or pay for school? While that type of windfall is a blessing, you also might also be wondering if you need to pay taxes. Understanding what you’ve received and where taxes fit in could help you save thousands of dollars. This article covers those different account types and gives tips on how to save taxes on your inheritance.

Banking Accounts

First the good news! Most bank accounts only hold cash, and cash received as an inheritance is not actually taxed.  This is because cash does not grow in value, and the IRS has excluded cash inheritances from being taxed. However, there are six states that have state-level inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Retirement Accounts

Retirement accounts, on the other hand, are taxed when distributions are made from the inherited retirement account.  The distribution is taxed at your ordinary income tax rate.

The government also mandates inherited retirement accounts to make distributions over time. These distributions are known as Required Minimum Distributions (RMDs), and the distribution schedule is based on the relationship you have to the deceased. In general, the rules are as follows: 

  • Spouse: If you had a spousal relationship to the deceased, you’re required to withdraw money according to either your life expectancy or your spouse’s life expectancy
  • Non-Spouse: For IRAs inherited from non-spouse owners who have passed away on or after January 1, 2020,  you must withdraw all assets within 10 years following the death of the account holder.

This is a simplification of the overall tax rules, but knowing this information can help you plan accordingly in reducing your overall income tax. In fact, here are five tips to consider when taking RMDs from your inherited retirement accounts.

  1. Know your RMD amount needed each year. Some firms, such as mutual fund companies, will send notices in the mail to remind you. However it’s best to not rely on these notifications. Your broker or advisor should have this information available to you. .
  2. Plan accordingly for the future: There are various online calculators that can help estimate your required RMDs in future years.  Use this to your advantage.  Planning ahead allows you to find ways to reduce your ordinary income, such as through charitable donations, retirement contributions or itemized deductions.
  3. Make Charitable Donations Directly:  If you’re someone who donates to charities, consider making the donation from the inherited retirement account. For example, our clients who donate 10% of their annual income to their church send some or all of their RMD amount directly from their accounts to their church. And because it’s a charitable donation, it also doesn’t count as ordinary income on their taxes. This allows them to make their annual charitable contribution, fulfill their RMD requirement, and avoid paying taxes! However, this donation may not be included as an itemized deduction.
  4. Remember to take your RMD. If your required distribution is not taken, the IRS may charge a 50% tax! So even if you’re uncomfortable paying more taxes, it’s best to take your RMD, since the tax will surely be less than a 50% tax hit.
  5. Know the exceptions for non-spousal heirs. If you are disabled or chronically ill, the IRS waives the 10 year requirement.  Distributions will still need to be made annually, but they can be much smaller because the distribution is based on your life expectancy and not 10 years. Minors are also able to avoid the 10 year rule while they are under 18.  Once over 18, the clock starts ticking.

Non-Retirement Accounts

Perhaps grandma built up a nest egg in a non-retirement account and then bequeathed it to you in her will.  When you sell those investments, the gain from those investments will be taxed at the capital gains rate, which is normally 15 to 20%. 

However, there’s actually a strategy that you’ll want to take advantage of, called the step-up in cost basis, to reduce your taxes. This is a rule in the tax code that allows you to update the initial purchase price of the investments to a value based on the decedent’s date of death. 

Here is how a step up in cost basis can help you save on taxes. Often, inherited assets have been purchased many years ago. By stepping up an inherited investment’s cost basis, realized gains are reduced. This in turn decreases your corresponding taxes on the gain. 

For example, one of our clients purchased a stock for a few thousand dollars more than 40 years ago. That stock is now worth more than a million dollars! When our client passes away, a step up in cost basis will change the realized gain for her children and grandchildren from being over $900,000 to something a lot less (e.g. tens of thousand dollars). At a 15 or 20% tax rate, this could be over $150,000 in savings just for updating some data.

However, it’s important to know that a step up in cost basis does not necessarily happen automatically.  And for some accounts, such as inherited assets that were in joint accounts, you might have to go out of your way to update your cost basis.  If you don’t, the IRS will be more than happy to use the original cost basis when levying a tax on any sale proceeds.

So here are three things to do in order to update your cost basis for an inherited investment.

  • Have an accountant or investment advisor help you in computing your updated cost basis.  The formula to compute an investment’s date of death value is based on the date of death. However, it’s not as simple as finding the value of the investment for a specific date.  And for assets that are not actively traded on a stock exchange like the NYSE or NASDAQ, it can get even more complicated. An accountant or investment advisor can help with accurate data and correct computations. 
  • Update your basis with your broker. With correct cost basis numbers in hand, you’ll need to update your basis at the brokerage where your inherited investments are held. Some brokerages provide tools online that allow you to update basis immediately; others might require you to contact customer service.  It’s important to update your cost basis at your broker so when you sell your investment, the basis will be reflected in your tax documents.  
  • Check your monthly statements. Once you’ve sent your data to your broker, it’s important to check your monthly statements to confirm that the basis has been updated correctly.

In summary, knowing these tips and the difference between the type of accounts and assets you’ve inherited, whether it be in cash, retirement, or non-retirement accounts, can help you save taxes on inherited assets.  For more questions or more specific financial planning situations, please feel free to reach out to us!

Jared Ong

Jared Ong oversees portfolio management, trading and technology. He previously worked at the Capital Group as a business systems analyst where he was integral in improving the trade operations group’s equity, fixed income, and foreign exchange trade processes. A graduate from Brigham Young University, Jared holds a Bachelors in Music. In his spare time, he enjoys composing and arranging music.