Laura answers a listener's question about paying tax on an inheritance and managing it wisely.
Laura answers a listener's question about paying tax on an inheritance and managing it wisely.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Emily G., who says:
"I'm 28 with an annual income of $47,000 and no debt. I just inherited a little over $200,000 from my father, who recently passed away. It came from selling his property, which I owned for less than a year. How will that affect my taxes and any capital gains?
Also, what are your recommendations for managing my inheritance? I've been told to invest in multiple CDs but am uncertain about what to do with it."
I appreciate your questions, Emily, and I am sorry to hear about your father's passing. This post will review how an inheritance may get taxed. Knowing the rules for you or your beneficiaries can help with estate planning and minimizing taxes. Plus, we'll review how to make the most of an inheritance based on your situation and financial goals.
Thanks for downloading episode 891 of the Money Girl podcast! I'm Laura Adams, an award-winning author, money speaker, on-camera spokesperson, and consumer advocate.
You can learn more at LauraDAdams.com and contact me about PR and marketing work or speaking appearances! That's also where you can sign up for my free Substack newsletter, The Money Stack, which gives subscribers a terrific Money Success Toolkit.
If you have a question about money, use my contact page at LauraDAdams.com or leave a message 24/7 at 302-364-0308.
What happens to my belongings when I die?
If a family member or friend leaves you an inheritance, you may be like Emily, wondering if you owe taxes. The answer depends on factors like the tax laws in your state, what you inherited, the inheritance value, and your relationship with the deceased person.
First, let's review what happens to your belongings when you die. The total value of your assets–like cash, investments, real estate, vehicles, collectibles, and all personal possessions–is your "estate."
While an estate sounds like something only for wealthy people, estates can be large or small and don't necessarily include land. Since your estate must pay your debts, it's equivalent to your net worth, or your assets minus your liabilities, at the time of your death.
Every adult should have a will that names an executor to manage their final wishes and the estate's financial affairs. Your executor is responsible for paying applicable estate taxes and liabilities and distributing any remaining assets to your beneficiaries.
Your executor can be a professional, like an attorney, or a family member or friend, even if they're also a beneficiary named in your will. If you don't have a will or an executor, a court will appoint an executor, which may not resolve your estate the way you'd like.
So, if you don't have a will, make creating one and naming an executor a top priority this year. If you have minor children or other dependents, you should also name a guardian
in your will who would physically and financially care for them if you died.
When your estate gets settled through the legal process known as probate, it may owe an estate tax ranging from 18% to 40%. However, that hefty tax only applies to estates valued over $13.61 million in 2024. The estate tax threshold will increase to $13.99 million in 2025.
In addition, thirteen states impose various estate taxes. For instance, in Oregon, estates over $1 million get taxed from 10% to 16%. In Connecticut, amounts over $13.61 million get taxed at 12%.
So, the federal and state estate taxes typically only apply to high-net-worth decedents unless Congress lowers the exemption in the future. Therefore, if you have significant assets, work with an estate planner to minimize taxes to preserve wealth for your heirs.
Do I have to pay an inheritance tax?
Once an executor distributes your available estate assets, different taxes may apply for each beneficiary. Emily may be glad that the federal government does not consider most inheritances taxable income.
In other words, you don't have to pay ordinary or capital gains taxes if you receive cash, stocks, mutual funds, real estate, vehicles, collectibles, or valuable personal property.
However, as of 2024, the following six states impose a state inheritance tax:
Even if you live in one of these states, you may be exempt from paying tax on some or all of an inheritance. For example, inherited amounts over $100,000 get taxed from zero to 15% in Nebraska. Iowa has no exemption but imposes a tax from zero to 2%.
Plus, in most states, you don't owe tax when you inherit property from a deceased spouse. So, be sure you understand the inheritance rules in your state so you can reduce your taxes.
In addition, certain assets and untaxed income that would have been taxed as ordinary income to the decedent are taxable. It's called "income in respect of a decedent" or IRD and may include uncollected salary, pension income, and traditional retirement accounts. I'll discuss inheriting retirement accounts in a moment.
If you're the beneficiary of someone's life insurance policy, the proceeds are generally not subject to income or inheritance taxes. Since they're not part of the deceased person's estate, the funds don't go through probate and get paid directly to the policy's beneficiaries.
Do I have to report my inheritance on my tax return?
Since a typical inheritance isn't subject to federal taxes, it doesn't need to be reported on your tax return. But, as I mentioned, there are six states where you may need to declare it.
In addition, any earnings you receive from inherited assets must be reported as taxable income on your federal and any applicable state income tax return. For example, earning interest on an inherited cash account or rent from an investment property would be taxable.
To sum up, an estate tax is levied against the taxable estate of a deceased person by the federal government and thirteen states. An inheritance tax is levied against individuals who receive an inheritance, but only in the six states I mentioned, and the taxable amount varies significantly from state to state.
You can see a complete list of estate and inheritance taxes by state at Taxfoundation.org.
What is a step-up-in basis?
A tax provision known as a step-up in basis is favorable for most beneficiaries because it reduces capital gains tax when you sell an inherited asset. Capital gains are calculated on the difference between an asset's selling price and cost basis or its original purchase price.
When you inherit an asset, its basis gets adjusted or stepped up (or down) to its fair market value on the previous owner's date of death. That resets the cost basis of any appreciated inherited asset for tax purposes, reducing or eliminating capital gains taxes when the new owner sells it.
Let's say the property Emily inherited was purchased for $50,000 many years ago and appraised for $200,000 when her father died. A few months later, she inherited the property and sold it for $200,000. In that case, Emily would owe no inheritance taxes on the property or capital gains taxes for selling it.
However, if the property Emily inherited was worth less when her father died, and she sold it for a profit, then she would have a taxable capital gain. For instance, if the fair market value or stepped-up basis was $175,000 and Emily sold the property for $200,000, she'd have a $25,000 taxable capital gain.
Emily mentioned owning the property for less than a year, which would make any potential gain subject to the short-term capital gains tax, which is the same as ordinary income tax rates, ranging from 10% to 37%, depending on your income and tax filing status. So, any capital gain would be added to Emily's total taxable income for the year.
Selling an asset for a profit after owning it for more than a year means you owe long-term capital gains tax, ranging from zero to 20%. That means you get favorable tax treatment for owning an asset or investment longer than a year before selling it, especially if you're a high earner.
Emily may owe short-term capital gains tax, the same as her ordinary income tax rate, if she sold her inherited property for a gain exceeding its stepped-up basis. If you're unsure about the basis of an inherited property or how to calculate a capital gain, consult a certified tax professional.
What are step-up-in basis exceptions?
There are some exceptions or limitations of the favorable step-up tax treatment for heirs. One is owning an asset jointly with the deceased. In that case, you only get a step-up on their portion of appreciation at the time of their death, but not on your portion.
For instance, if you own a home 50/50 with a parent and they pass away, only half of the basis would get adjusted to its fair market value at the time of their death. Your half would remain equal to the property's original basis for tax purposes when you sell the property.
When you own real estate as a married couple with rights of survivorship, the surviving spouse automatically inherits the deceased spouse's share and gets a step-up for half the appreciated value at the time of their death.
However, suppose you live in one of nine community property states, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin, and are a surviving spouse. In that case, you receive a stepped-up basis for both ownership portions or the full amount of the community property.
Again, speak with a qualified tax professional if you have questions about the value and tax liability of an inheritance.
RELATED: How to avoid capital gains taxes (legally) on your home sale
What is the gift tax?
Note that if someone gives you an asset while alive, instead of leaving it to you after they die, the asset won't qualify for a stepped-up basis. However, transferring high-value property to loved ones or charities during your lifetime could reduce future estate taxes and provide financial support sooner rather than later.
If you give away money or assets, you can give an amount annually without reducing your lifetime estate tax exemption ($13.99 million for 2025). You can give away up to $19,000 per person without needing to file a gift tax return, IRS Form 709.
The gift return allows the IRS to keep up with your lifetime estate tax exclusion because the amounts you give away over the annual exemption per person reduce the size of your estate when you die.
What to know about inheriting a retirement account
If you inherit a retirement account, like a traditional or Roth individual retirement account (IRA), there is never a step-up in basis. Tax-advantaged retirement accounts don't get any adjustment when you inherit them but must be included as income when you take required withdrawals.
Let's say your spouse dies and you inherit their IRA. In that case, you can transfer it into your own IRA or a new inherited IRA account. If you inherit an IRA from someone who wasn't your spouse, such as a parent, sibling, or friend, you must empty the account within ten years and pay all applicable federal and state income taxes. Depending on the IRA value, that could significantly increase your taxable income over the next decade.
For pre-tax, traditional IRAs, you must take taxable, annual required minimum distributions (RMDs) starting at age 73. However, there are no RMDs when you inherit an after-tax Roth account.
If you inherit a retirement account and the deceased previous owner had not started taking RMDs, you aren't obligated to make a distribution every year. So, be strategic and stay in the lowest tax bracket possible over the ten-year withdrawal period. For instance, if you have a low-income year, you might empty the entire account instead of spreading out withdrawals over multiple years. While you must empty an inherited Roth account within ten years, you always enjoy tax-free withdrawals.
ALSO LISTEN: What tax will I owe on my investments?
How to make the most of an inheritance
Emily asked about the best way to manage a $200,000 inheritance. Whenever you experience a significant life event, like the loss of a close family member or receiving a considerable windfall, take the time to review your finances, set new priorities, and if needed, meet with a financial advisor.
If you haven't listened to podcast 785, 6 Smart Steps for Managing a Cash Windfall, that's a good place to start, and I'll summarize the show here.
1. Identify the purpose of your money.
The first step for successfully managing a windfall is identifying its purpose. For instance, do you need it for short-term expenses, like buying a car or paying down high-interest debt? Or should it be set aside for your long-term goals, such as buying a home or retiring?
2. Review your financial safety nets.
Emily is in a great position with no debt, but she didn't mention having savings. If she doesn't have FDIC-insured savings with at least three to six months of her living expenses, that's where some of her inheritance should go.
Emergency money is essential for managing unexpected expenses and hardships, like losing your job, making home repairs, or paying medical bills. Plus, a healthy emergency fund can be the ticket for staying out of debt when surprise bills pop up.
ALSO LISTEN: The Right Amount of Emergency Money to Keep In Cash
3. Put your retirement on autopilot.
Emily didn't mention having investments like a workplace retirement account or an IRA. I recommend she max out a Roth IRA by contributing $7,000 for 2024. You have until your tax filing deadline to make IRA contributions for the previous year.
The deadline to contribute to a workplace retirement plan, like a 401(k) or 403(b) is December 31. If Emily has one, she could set up automatic Roth contributions to max out the account by the end of 2025, contributing $23,500 or about $900 every other week. She could also automate contributions to a Roth IRA by contributing about $270 every other week.
ALSO READ: Too Rich for a Roth? 3 Legal Ways to Have One
4. Create a diversified portfolio.
If Emily's IRA or workplace retirement account is with a well-known investing firm or robo-investing platform, there's no shortage of excellent investment choices, like mutual funds, index funds, and exchange-traded funds (ETFs), that give you a diversified portfolio.
A diversified portfolio allows you to earn higher average returns while reducing risk. If some securities within a fund lose value, some will hold steady or increase in value, minimizing potential losses.
5. Consider your risk tolerance.
While the stock market can be volatile, its historical average return has been approximately 10% since the 1920s. So, if you're decades away from retirement, with plenty of time to recover from temporary market downturns, most of your portfolio should be in stock funds.
Emily asked about putting her money in CDs, which could be an option for a portion of her cash after funding a liquid high-yield savings account and maxing out available retirement account options. However, she can earn higher returns by investing some or all of her remaining money in a diversified index fund using a brokerage or robo-advisor.
6. Get investment advice when you need it.
Getting a significant windfall like a gift or inheritance is a fantastic opportunity to improve your finances that you shouldn't squander. If you're unsure how to manage it or choose investments, get advice from a certified financial professional, tax accountant, or retirement planner.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio-engineers the show. Brannan Goetschius is our director of podcasts, Holly Hutchings is our digital operations specialist, Morgan Christianson is our advertising operations specialist, Davina Tomlin is our marketing and publicity associate, and Nathaniel Hoopes is our marketing contractor.