By John Mlynczyk
So Aunt Sally passed away this year and you received word from the executor that you are a beneficiary of her estate. Will your inheritance be taxable? The short answer to this question is “it depends.” Inherited assets may be subject to an estate level tax and they might be subject to income tax with respect to the beneficiary who receives the assets. It is important to note that the executor is liable for payment of estate taxes, and the beneficiary may be liable for income taxes.
Federal Estate Tax
You may have heard of the federal estate tax in recent news as it is a subject of much controversy. Currently, the federal estate tax imposes a top tax rate of 40% on taxable estates in excess of $5.45 Million (or $10.9 Million for married couples). Thus, if Aunt Sally died in 2016, she was single, and her taxable estate was worth more the $5.45 Million, federal estate tax is likely due. Essentially, the IRS is the first “beneficiary” waiting in line. The taxes owed to the IRS may reduce your share of any inheritance.
Oregon Estate Tax
You may not have heard of the Oregon estate tax. In fact, Oregon is in the minority of states that continue to assess a state level estate tax. Oregon imposes a top tax rate of 16% on taxable estates in excess of $1 Million. Supposing again that Aunt Sally died in 2016, she was an Oregon resident (or held assets in Oregon), and had a taxable estate in excess of $1 Million, Oregon estate tax is likely due. Even if Aunt Sally’s estate wasn’t large enough to trigger federal estate tax, she may still owe estate tax to Oregon. Again, the Oregon estate tax may reduce your share of any inheritance.
Inherited assets may be subject to income tax depending on the type of assets you inherit. Most inherited assets fall into one of 3 broad categories: 1) Tax free, 2) Taxable now, and 3) Taxable later (maybe).
Tax free assets include things such as cash or life insurance proceeds paid out upon the death. While cash accounts and life insurance proceeds are included in the value of the decedents estate (for estate tax purposes), they are generally income tax free. Therefore, if part of your inheritance is related to Aunt Sally’s bank account or the proceeds from her life insurance, it’s probably tax free.
Assets in this category are often called “income with respect to a decedent” assets and may include assets such as wages payable to the decedent, inherited 401k and Traditional IRA accounts, and many annuity products. In general, these are assets that would have been ordinarily taxable to the decedent. As the beneficiary, you step into the Aunt Sally’s shoes paying income taxes on monies when received from these types of accounts. Furthermore, special IRS rules often require you as the beneficiary to take money out of these accounts over time.
Taxable Later (Maybe)
Most other inherited assets fall into the “taxable later” category. These types of assets may include brokerage accounts, individual security holdings, real estate, personal property, and even shares in the family business. The internal revenue code provides a special rule that allows for a tax basis step-up upon death. This is to say, the beneficiary receiving those assets takes a basis in those assets equal to their fair market value at date of death and the beneficiary pays no income tax today. However the beneficiary may pay tax down the road if those assets are sold at a gain (or the beneficiary may realize a loss upon sale). The beneficiary may also be liable for income tax on net earnings (interest, dividends, etc.) received by the executor after the date of death and distributed to the beneficiary as part of their share of the estate.
Income Taxes – Comprehensive Example
Suppose you inherited the following assets from Aunt Sally: $50K of life insurance, $25K Traditional IRA, and 100 shares of Apple Inc valued at $80 per share at her death. As we have learned, the life insurance is not subject to income tax. Moreover, the IRA is taxed when you take the money out of the account. Finally, the Apple shares are taxable when you sell them later, but any post-death dividends received on the Apple shares may be taxable when the dividends are distributed to you. For example, suppose you sell the Apple shares at a later date for $110 per share, you will pay tax on the $30 gain per share.
As you can see the taxation of your inheritance can quickly become complicated. We encourage you to work with your CPA to plan and prepare for these complicated estate and tax matters.