Icing on the Inheritance Cake
No Federal Tax on Most Inherited Assets
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
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.
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.