Icing on the Inheritance Cake

No Federal Tax on Most Inherited Assets

AUGUST 2011

       

Icing on the CakeThe good news for heirs is that any inherited assets are not included in income for federal tax purposes. For the most part, it’s all proverbial “icing on the cake.” There are a few states that have a state tax on the inheritance that you receive, but it’s typically a very low rate for close relatives and is not imposed on the surviving spouse. Those states include: Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee.

DO YOU LIKE THE SOUND OF ZERO FEDERAL TAX?

Of course, your “zero federal tax” is based upon the assumption that the estate of the decedent has paid its taxes before you receive your inheritance. Typically, when a decedent passes away, the individual’s estate is required to file a final return for the decedent reporting the income and deductions up to the date of death. For income received and deductions paid after the date of death, an estate must collect and report income and deductions on an estate income tax return. Then, any taxes owed by the estate need to be paid by the estate before inheritance distributions.

THE K-1 DISTRIBUTION

When an individual receives an inheritance distribution, a K-1 is also issued that shows his/her share of the income and deductions reported by the estate on its income tax return. Even though the individual doesn’t have to pay income tax on the inheritance as reported on the K-1, any income tax on the net earnings after allowable expenses generated by the inherited assets must be paid—once those assets are in that individual’s possession.

If inherited property is sold, the individual will be taxed on the appreciation that occurs after the decedent's death. By law, heirs are automatically presumed to have held investment type inherited property for more than one year, which if sold, entitles individuals to long-term capital gains rates at a maximum rate of 15%.

WATCH OUT FOR IRD.

Sometimes IRD items are forgotten or overlooked—which leads to unnecessary tax penalties. So what is IRD? IRD is the acronym for “Income in Respect of a Decedent.” In other words, it is the income that the deceased person would have reported on his/her final income tax. IRD includes the decedent’s last paycheck plus any other compensation-related benefits paid after death, such as accrued vacation pay or voluntary employer benefit payments. Since this income was technically received after the decedent’s death, it is not included in the deceased person’s final income tax return. Instead, it is reported on the income tax return of the estate or an heir. The typical best practice for handling this issue is to pay the IRD into the estate.

TAX-DEFERRED ACCOUNTS

If you inherit a tax-deferred account such as a 401(k), IRA, or a pension account, any distributions taken are subject to the same income tax as if the decedent took a distribution. If you inherit tax-deferred accounts, you will probably want to enlist the help of tax counsel regarding required distributions. Of course, any investment income generated by the inherited funds (once you receive it) is subject to normal taxation.

ASK MORE, PAY LESS.

CRI offers the knowledge and perspective to help you maximize your inheritance while minimizing your taxes. And the best news? We’re happy to help and only a phone call away.