Inheritance Tax Checklist: Know Before You Sell

Dana Anspach

May 12, 2020

Inheritance taxes are complicated. Many people don’t realize that inherited assets—property, stocks, investment accounts, etc.—may be subject to taxes and that there are specific tax rules for each type of asset or account. So before you start selling off assets, make sure you know the rules.

We are not talking here about estate taxes. Estate taxes apply to the total value of everything you own; real estate, stocks, bonds, retirement accounts, defferred annuities, businesses, farms, and even the death benefit values of any life insurance policies owned by you. With current 2020 estate tax rules, federal estate taxes will only impact singles with an estate of $11.58M or more, or married couples (if they’ve done proper planning) with an estate worth $23.16M or more. Needless to say, federal estate taxes will not affect most of us. (Note: some states still assess a separate state-level estate or death tax.)

So, if we’re not talking about estate taxes, what are we talking about when we say ‘inheritance taxes?’ We’re talking about various types of income taxes owed on inherited assets.

Regardless of the value of the decedent’s estate, you may still owe income taxes on certain assets that were left to you. Here’s a checklist of the most common assets that beneficiaries inherit and information on the relevant taxes:

  • Inherited IRAs: If you already have a traditional IRA, 401(k) or other tax-deferred accounts like a 403(b) or SIMPLE plan, you know that the money inside these types of accounts has not yet been taxed. When you inherit such accounts and withdraw money, the amount withdrawn is considered income. Some people cash in these accounts and are surprised when they get the bill for the taxes owed. Ouch. That’s not the kind of surprise you want to get.

Previously, with an inherited IRA, you could take required distributions based on your life expectancy. If you desired, you could have taken out more than this amount, but not less. With this approach, you would have only had to withdraw Required Minimum Distributions (RMDs) each year, allowing you to stretch the income and taxes on this inheritance. But not anymore.

With the passing of the Secure Act in 2019, a non-spousal beneficiary will no longer be able to take advantage of life expectancy RMDs and extended tax defferral. Instead, they are required to withdraw the inherited account within ten years, which could result in putting a beneficiary in a higher tax bracket.

  • Inherited 401(k)s: You will have to pay income tax on the amount you withdraw from an inherited 401(k). Spouses, minor children, and beneficiaries with disabilities can still withdraw RMD’s over their life expectancy. However, for non-spousal beneficiaries, due to the SECURE Act of 2019, the same rules for IRAs apply to 401(k)s as well.
  • Inherited mutual funds and stocks: There are different tax rules for inherited mutual funds or stocks that are not held inside retirement accounts. Typically, when you sell a stock or fund, you pay capital gains tax on any gain that has occurred since you bought it. The amount you originally bought it for is called your cost basis. When you inherit these types of assets, for tax purposes, the cost basis is based on the fair market value of the stock or fund or at the time of the decedent’s passing. This is commonly referred to as a “step-up” in cost basis. So, if your parent bought a stock for $100 and it was worth $200 at their death, for tax purposes, you can “step-up” the cost basis to $200. Here’s an interesting detail: you can choose the fair market value of the fund or stock to be the date of the decedent’s death, or you can choose the fair market value as of six months after death; if you use six months after, you have to choose this alternate valuation date for all assets. To use an alternate valuation date, you must make an election on IRS Form 706, within one year of the due date of the federal estate tax return, including extensions.  When you sell the asset, you will either have a capital gain or a loss depending on the difference between the cost basis and the value of the asset when you sell it. To estimate the taxes on cashing in inherited accounts of any kind, you can run a tax projection to see what taxes you will pay if you go that route.
  • Inherited home/property: When you inherit a home, the cost basis for tax purposes is either the value of the home on the decedent’s date of death or the fair market value six months later if you chose the alternate valuation date. So, if the house was worth approximately $200,000 at the decedent’s time of death and you sold it eight months later for $220,000, you will have $20,000 of capital gains to report on your tax return. However, and this is very important, you might be able to exclude up to $250,000 of gain if the deceased lived in the home for at least two of the last five years. Unfortunately, if there is a loss on the sale, you will not be able to use it as a deduction. A good tax preparer can help you figure all this out. Another vital detail to note: if the decedent added you as a joint owner of the property, you might forfeit some of your step-up in cost basis. In our example, where the house is worth $200,000, let’s assume the decedent was your parent, and they bought the house for $100,000. Thinking they were doing the right thing, they added you to the title of the home. Now, upon their passing, you only get a step-up on half the value of the home. Their half of the home has a basis of $100,000, but your half has a basis of $50,000, so for tax purposes, the basis is $150,000. Now, when you sell it, taxes may be owed on $70,000 instead of only $20,000. Yikes!
  • Artwork and jewelry: If you inherit artwork, jewelry, or collectibles and you sell them, you will have to pay taxes on the net gain of the sale. Upon the sale of inherited collectibles, there is a hefty 28% capital gains tax rate, as compared to the 15% to 20% that applies to most capital assets. To determine the cost basis, you use the value at the date of death or the alternate valuation date. The difference between the sale price and the cost basis is the amount that is subject to taxation. Items in this category include anything that is considered an item worth collecting. Generally, items such as rare stamps, books, coins, art, fine wine, glassware, and antiques all fall under the collectibles umbrella.

Financial Sense Newsletter

A final few words of advice. After a loved one passes, and you are in mourning, regardless of how smart and savvy you are, you will be vulnerable not only because of your emotional state but simply because you will be learning about new and complicated topics. Don’t be fooled by creditors who may attempt to collect debts from family members of a deceased person. These claims should be made against the estate, not against you. You may also inadvertently fall victim to someone, who, learning of your recent windfall, tries to sell you investments or insurance products. Do not make any investment or insurance purchases without going through a comprehensive financial planning process.

Tax laws are complex. If you expect to receive an inheritance, this might be the perfect time to start searching for a qualified professional who can help you decide what to do based on your situation and future goals.

If you like our common-sense style, subscribe to our monthly newsletter, Financial Sense, where you’ll hear about free upcoming online classes, podcasts, and get more great information on aligning your finances for retirement.

Free Report