When I first encountered the question, “Are inherited investment accounts taxable?” I found myself delving into a complex and often confusing area of tax law. It’s a question many individuals grapple with when they inherit investment accounts such as stocks, bonds, mutual funds, and retirement accounts. The good news is that, while the subject is intricate, I’ve broken it down into clear sections so that you can fully understand how inherited accounts are taxed and how to manage your inherited assets effectively.
In this article, I’ll guide you through the tax implications of inherited investment accounts. We’ll explore different types of accounts, how the tax rules apply, and how they affect you, whether you’re the inheritor or the person leaving the accounts behind. You’ll also find examples, tables, and comparisons to help illustrate key points.
Table of Contents
What Are Inherited Investment Accounts?
An inherited investment account is an account you receive after someone’s death. These can include:
- Brokerage Accounts: These are general investment accounts that hold stocks, bonds, mutual funds, and other types of securities.
- Retirement Accounts: This includes IRAs, 401(k)s, 403(b)s, and other tax-deferred retirement plans.
- Trust Accounts: Sometimes, investments are held in a trust, which is a legal entity that holds assets for the benefit of another person.
The nature of these accounts can vary, but understanding the tax treatment of each is essential.
Taxation of Inherited Brokerage Accounts
When I inherited a brokerage account, I wanted to understand exactly how it would be taxed. The general rule for inherited brokerage accounts is that they are not subject to estate taxes when you inherit them. However, income generated from the investments within those accounts is subject to regular income tax.
For example, if you inherit an account with stocks that pay dividends, those dividends are taxable to you in the year they are paid. Similarly, if you sell the stocks and make a capital gain, that gain is also taxable.
Capital Gains Tax on Inherited Brokerage Accounts
One of the key aspects of inherited brokerage accounts is the step-up in basis rule. Here’s how it works: If you inherit an asset, the cost basis of that asset is stepped up to its market value on the date of the original owner’s death. This is a significant advantage because it reduces any potential capital gains tax you might owe when you sell the asset.
For example, let’s say your relative bought 100 shares of a stock at $10 per share, but at the time of their death, the stock is worth $50 per share. If you sell the shares immediately after inheriting them, you would pay no capital gains tax since your cost basis is now $50 per share—the market value on the date of their death.
Capital Gains Calculation Example:
- Original purchase price of stock: $10 per share
- Market value at the time of inheritance: $50 per share
- You sell the stock immediately after inheriting: Sale price = $50 per share
- Capital gain = $50 (sale price) – $50 (step-up basis) = $0 (no capital gains tax)
However, if you hold onto the stock for a longer period and its value increases, then any gains made after the date of inheritance will be subject to capital gains tax.
Taxation of Inherited Retirement Accounts
The rules surrounding inherited retirement accounts are different from those for brokerage accounts. The tax treatment depends on the type of retirement account, the relationship between the deceased and the inheritor, and whether or not the original account holder had already begun withdrawals.
Traditional IRA or 401(k) Accounts
When you inherit a traditional IRA or 401(k), the distributions you receive are taxable as ordinary income. This means that any withdrawals you make from the account will be taxed at your regular income tax rate. This can be significant, especially if the account balance is large.
One of the most important changes from the SECURE Act of 2019 is the elimination of the stretch IRA for most beneficiaries. This change requires most non-spouse beneficiaries to withdraw all assets from an inherited IRA or 401(k) within 10 years of the original account holder’s death. These distributions will be subject to income tax in the year they are received.
Example of Traditional IRA Taxation:
Let’s assume your parent left you a traditional IRA with a balance of $200,000. If you decide to take a distribution in the first year, it will be taxed as ordinary income. If you withdraw $20,000, you will pay income tax on that amount based on your tax bracket.
- Traditional IRA balance: $200,000
- Distribution for the year: $20,000
- Taxable amount: $20,000 (subject to ordinary income tax rate)
If your tax bracket is 24%, your tax liability on the $20,000 would be $4,800.
Roth IRA Accounts
Roth IRAs are treated differently. When you inherit a Roth IRA, you are not required to pay taxes on the distributions, as long as the account has been open for at least five years. This means that, if the original account holder had already met the five-year requirement, you can withdraw money from the Roth IRA without worrying about income tax.
However, like traditional IRAs, the SECURE Act requires you to take distributions within 10 years of the original account holder’s death.
Example of Roth IRA Taxation:
If you inherit a Roth IRA worth $100,000 and you withdraw $10,000, that $10,000 is not subject to income tax. This can provide significant tax savings over time.
- Roth IRA balance: $100,000
- Distribution for the year: $10,000
- Taxable amount: $0 (no tax due)
Trust Accounts
Trusts can be a bit more complicated because the tax treatment depends on whether the trust is revocable or irrevocable. If the trust is revocable, meaning the original owner can modify or revoke it during their lifetime, it’s taxed similarly to their personal estate. The assets in the trust would typically transfer to the beneficiary after the original account holder’s death, and you would pay taxes based on the type of assets you inherit.
Irrevocable trusts, on the other hand, are more complex. They generally hold assets that are transferred out of the original owner’s estate, and the beneficiary would need to pay income tax on any income generated by the trust. Additionally, if the trust distributes income to you, it may be subject to tax at the trust’s rate, which can be higher than individual tax rates.
Comparison Table: Inherited Account Taxation
| Account Type | Taxable Income | Step-Up in Basis | Distribution Timeline | Tax Treatment |
|---|---|---|---|---|
| Inherited Brokerage Account | Yes, on dividends and capital gains | Yes, on capital gains | No specific timeline | Taxed on income and gains |
| Inherited Traditional IRA | Yes, on all distributions | No | Within 10 years | Taxed as ordinary income |
| Inherited Roth IRA | No, on qualified distributions | No | Within 10 years | Tax-free if rules are met |
| Inherited Trust Account | Yes, on income from the trust | Depends on trust type | Varies by trust | Taxed on income generated by the trust |
Other Important Considerations
Estate Taxes
In addition to income taxes, it’s important to note that estate taxes may apply to the overall estate of the deceased. If the estate exceeds a certain threshold, the estate itself may be subject to federal estate taxes before the assets are distributed to heirs. However, most estates do not exceed this threshold, so estate taxes are not something the average person needs to worry about.
State Taxes
Some states have their own estate and inheritance taxes, which can differ from federal laws. Be sure to check the rules in your state, as they may impact how much you owe when inheriting investment accounts.
Inherited Accounts and the 10-Year Rule
For many beneficiaries, one of the biggest changes due to the SECURE Act is the 10-year rule for inherited IRAs and 401(k)s. You must fully distribute the funds within 10 years, but you are not required to take annual required minimum distributions (RMDs) as long as the entire balance is withdrawn within the decade.
Conclusion
As I’ve learned, the tax treatment of inherited investment accounts depends on the type of account and how it’s structured. Brokerage accounts typically involve capital gains taxes, while retirement accounts have different rules, especially following the SECURE Act. Understanding these rules can help you avoid surprises and make the best decisions for your financial future. Whether you’re dealing with a traditional IRA, Roth IRA, or brokerage account, the key is to stay informed and work with a tax professional to navigate these rules effectively.
Understanding taxes on inherited investment accounts is essential for making smart financial decisions after a loved one’s passing. Be sure to stay updated on the latest tax laws to ensure that you make informed choices about your inherited assets.
