Inheriting investments can feel like receiving an unexpected gift, but that gift comes wrapped in complex tax rules that could catch you off guard. The difference between understanding these rules and stumbling through them blindly might mean thousands of dollars in unnecessary taxes or missed opportunities to grow your wealth.
The tax treatment of inherited investments varies wildly depending on what you inherit, when you inherit it, and how you handle it afterward. From stepped-up basis rules that could erase decades of capital gains to required distributions that must happen on strict schedules, the world of inheritance taxes requires careful attention to detail.
The Foundation: Stepped-Up Basis
When you inherit most investments held in taxable accounts, you receive what’s called a “stepped-up basis.” This rule resets the cost basis of inherited assets to their fair market value on the date of the original owner’s death.
This adjustment can provide substantial tax benefits. If your grandmother bought stock for $10,000 that’s worth $100,000 when you inherit it, your cost basis becomes $100,000. If you sell immediately, you owe no capital gains taxes on the $90,000 of appreciation that occurred during her lifetime.
How Step-Up Works
The stepped-up basis applies to various types of assets including stocks, bonds, mutual funds, real estate, and other tangible properties. According to the Joint Committee on Taxation, stepped-up basis accounts for $58 billion in forgone revenues for the federal government in 2024, highlighting just how valuable this provision can be for inheritors.
For married couples in community property states, the rules can be even more favorable. When one spouse dies, both halves of community property may receive a stepped-up basis, not just the deceased spouse’s portion.
Documentation Requirements
Establishing the stepped-up basis requires proper documentation of the asset’s value on the date of death. For publicly traded investments, this might be straightforward since market values are readily available. For real estate or other assets, you may need professional appraisals.
Keep detailed records of these valuations. Without proper documentation, the IRS might assume a basis of zero, leaving you to pay capital gains taxes on the entire sale price.
Inherited Retirement Accounts
Retirement accounts like IRAs and 401(k)s don’t receive stepped-up basis treatment. Instead, they come with their own complex set of distribution rules that have changed significantly in recent years.
The SECURE Act Changes
The SECURE Act of 2019 eliminated the “stretch” provision for most non-spouse beneficiaries. Previously, heirs could take distributions over their lifetimes, allowing for decades of tax-deferred growth. Now, most non-spouse beneficiaries must empty inherited accounts within 10 years.
New Rules for 2025
Starting in 2025, the IRS has implemented new rules that require annual distributions during the 10-year period if the original owner had already reached their required minimum distribution age. These rules apply to inheritances from account owners who died in 2020 or later, creating additional complexity for beneficiaries.
If you miss required distributions, you face a 25% penalty on the amount you should have withdrawn. The penalty can be reduced to 10% if you correct the mistake within two years, but it’s better to avoid the problem entirely.
Spouse vs. Non-Spouse Rules
Surviving spouses have more flexibility when inheriting retirement accounts. They can treat the inherited IRA as their own, delay distributions until their own required beginning date, or choose from several other options.
Non-spouse beneficiaries have fewer choices but still need to understand their options. The key is determining whether you’re an “eligible designated beneficiary” (such as a minor child, disabled individual, or someone within 10 years of the deceased’s age) who might qualify for different distribution rules.
Tax Planning Strategies
Understanding inheritance tax rules opens up opportunities for smart tax planning, both before and after inheritance occurs.
Timing Distributions
For inherited retirement accounts subject to the 10-year rule, you might benefit from spreading distributions evenly over the decade rather than waiting until the final year. This approach can help manage your tax bracket and avoid pushing yourself into higher tax rates.
Consider your current and projected future income when planning distributions. If you expect to be in a lower tax bracket in certain years, you might time larger distributions accordingly.
Asset Location Strategy
If you inherit both taxable accounts and retirement accounts, consider which assets to use first. Generally, it might make sense to spend from taxable accounts while allowing tax-deferred retirement accounts to continue growing, but your specific situation could warrant a different approach.
Common Mistakes to Avoid
Many inheritors make costly mistakes simply because they don’t understand the rules or act too quickly.
Premature Sales
Selling inherited investments immediately after receiving them might seem logical, but it could be a mistake. If you received a stepped-up basis, you have time to consider your options without immediate tax consequences.
Take time to evaluate whether the inherited investments fit your financial goals and risk tolerance before making wholesale changes.
Missing Deadlines
Retirement account inheritances come with strict deadlines and requirements. Missing these deadlines can result in penalties or lost opportunities.
For inherited IRAs, you typically must establish the inherited account by December 31 of the year following the original owner’s death. Failing to meet this deadline might force you into less favorable distribution options.
Commingling Assets
Don’t mix inherited retirement accounts with your own retirement assets. Inherited accounts must remain separate and follow different rules than your own retirement savings.
Similarly, if you inherit multiple accounts from the same person, understand which can be combined and which must remain separate.
State Tax Considerations
While federal tax rules provide the framework, state taxes can add another layer of complexity. In Tennessee, we don’t face the tax consequences, as Tennessee is very friendly from a tax perspective. However, those in other states may face challenges.
State Estate Taxes
Some states impose their own estate taxes with lower exemption amounts than federal rules. These taxes are paid by the estate before distribution, but they can affect the amount you ultimately inherit.
State Inheritance Taxes
A few states impose inheritance taxes on beneficiaries. The tax rate often depends on your relationship to the deceased, with spouses and children typically facing lower rates than more distant relatives.
State Income Tax
States handle the taxation of inherited retirement account distributions differently. Some states don’t tax retirement account distributions at all, while others follow federal rules or have their own unique provisions.
Professional Guidance Considerations
The complexity of inheritance tax rules often makes professional guidance valuable, particularly for substantial inheritances or complex situations.
When to Seek Help
Consider professional advice if you inherit retirement accounts worth more than $100,000, multiple types of assets, or if the inheritance affects your overall tax situation. The cost of professional guidance often pays for itself through tax savings and avoiding mistakes.
Types of Professionals
Different situations might require different types of expertise. Tax professionals can help with distribution planning and compliance, while financial advisors can help integrate inherited assets into your overall financial plan.
For complex estates involving trusts or business interests, you might need legal counsel in addition to tax and financial guidance.
Work With Us
Understanding the tax implications of inherited investments requires careful attention to complex and evolving rules that can have lasting effects on your financial future. From stepped-up basis calculations to required distribution schedules, each type of inherited asset comes with its own set of opportunities and obligations that must be handled properly to avoid costly mistakes.At Brogan Financial, we help clients understand and manage the complexities of inherited investments with confidence. Our team stays current with changing tax laws and distribution requirements, helping ensure you make informed decisions that align with your financial goals while maintaining compliance with all applicable rules. Whether you’re dealing with inherited retirement accounts, investment portfolios, or complex estate situations, contact Brogan Financial today to learn how we can help you maximize the benefits of your inheritance while minimizing tax burdens and avoiding costly errors.
