Inheritance Tax Planning: The Tax Surprises For Heirs

Takeaways

• Inheritance tax surprises don’t end when the estate closes. Income from estate assets and state-level obligations can linger.
• Retirement accounts don’t get a step-up in basis. Withdrawals from an inherited traditional IRA are generally taxed as ordinary income.
• Most non-spouse heirs must empty inherited IRAs within 10 years, and many must take annual distributions along the way.
• Two deadlines often warrant immediate attention: a potential year-of-death RMD and the nine-month qualified-disclaimer window. Other estate, tax, and account-specific deadlines may also apply.
• Inheritance tax planning works better as one coordinated picture, where the timing of IRA withdrawals shapes what you sell and what you give away.

Inheriting wealth and the grief that may accompany it sit uncomfortably with account statements and tax forms. Most people assume the hard part is deciding what to do with the money. In our experience, moving too quickly after an inheritance can lead to avoidable tax or planning consequences.

Good inheritance tax planning, like many big life decisions, starts with a pause. Two deadlines often warrant immediate attention: a potential year-of-death RMD and the nine-month qualified-disclaimer window. Other estate, tax, and account-specific deadlines may also apply.

Why taxes come first in inheritance tax planning

While heirs often assume the estate handled taxes, it rarely does entirely. Every inheritance has tax implications, but depending on how the estate was structured, you may face follow-up tax bills even if some taxes were already paid. Income generated by estate assets, state-level rules, and the deceased’s final returns can create obligations nobody expected.

Consider a hypothetical heir who cashes out a large inherited IRA in a single year. That withdrawal could push much of the distribution into the highest federal income-tax bracket. Spreading distributions over the applicable distribution period could produce a different tax result.

Examples in this article are hypothetical and for illustration only. Actual outcomes depend on your complete tax situation.

If you’re unsure where to start, that’s normal. Begin by understanding what you’ve inherited and how each asset is taxed. From there, you can separate what may require prompt attention from decisions that can wait.

Why the step-up in basis can be a gift in disguise

When you inherit an asset like a house or a stock portfolio, you may also inherit substantial appreciation. This is where the step-up in basis can become an important tax consideration.

Many inherited capital assets generally receive a basis adjustment to fair market value as of the applicable valuation date, subject to important exceptions. For example, if your parent bought a home for $200,000 and it’s worth $600,000 when you inherit it, a $600,000 basis may apply depending on the circumstances. That adjustment can substantially reduce capital gains taxes if you later sell.

Not everything receives a basis adjustment at death. Retirement accounts such as IRAs and 401(k)s generally do not. Withdrawals from an inherited traditional IRA are generally treated as ordinary income to the heir to the extent the distribution is taxable. Hypothetically, a $600,000 brokerage account and a $600,000 traditional IRA can therefore produce very different after-tax results. The linked Brighton Jones article addresses the post-SECURE Act beneficiary categories, 10-year framework, and inherited-account RMD considerations.

Heirs may also encounter after-tax money in an IRA. If the original owner made nondeductible contributions to a traditional IRA, that after-tax basis can carry over to the beneficiary, and the applicable portion of a withdrawal generally isn’t taxed again. IRS Form 8606 may provide important information about that basis, so locating the decedent’s tax records can be helpful before distributions begin.

The basis adjustment generally accounts for appreciation only through the applicable valuation date. Later appreciation may result in capital gain when the asset is sold. That can create an opportunity to evaluate whether a concentrated position or other inherited investment still fits the heir’s financial plan, without assuming that a particular transaction will necessarily produce a favorable tax result.

Even with no immediate plans to sell, documenting the applicable value early can help establish basis later. For real estate, that might mean an appraisal. Investment accounts may rely on applicable account statements and valuation records.

For jointly owned property, basis treatment depends on the ownership structure, state law, and other facts. Community-property rules can produce a different result from jointly owned property in non-community-property states, which is one reason coordinated tax and estate planning can matter.

For certain estates subject to federal estate tax, an alternate valuation election may be available. An executor may be permitted to value qualifying estate assets using alternate valuation rules rather than date-of-death values. Specific statutory requirements apply, including requirements concerning the resulting estate value and estate tax. The election generally applies across the estate rather than asset by asset. An estate attorney or tax professional should evaluate whether an election is available and appropriate.

Another consideration for estates that paid federal estate tax is the income in respect of a decedent, or IRD, deduction. In applicable circumstances, a beneficiary may be able to deduct federal estate tax attributable to inherited income items such as taxable IRA distributions. Whether the deduction is available depends on the estate’s and beneficiary’s specific circumstances.

Thinking through what you’ve inherited? Let’s look at your complete financial picture together. Schedule a complimentary intro call with a Brighton Jones advisor

Inherited IRA rules and the deadlines that may require prompt attention

When an inheritance arrives, many people feel pressure to act quickly to honor the gift and the person it came from. That urgency can lead to avoidable tax consequences.

Inherited retirement accounts carry their own rules. Under current inherited IRA RMD rules, most non-spouse designated beneficiaries must empty an inherited retirement account by the end of the applicable 10-year period. Exceptions apply to eligible designated beneficiaries and other situations.

Some beneficiaries subject to the 10-year rule must also take annual distributions during that period, depending in part on whether the original owner died before or after the required beginning date.

A missed required distribution can trigger a 25% excise tax on the amount that should have been withdrawn. The rate may be reduced to 10% when the shortfall is corrected within the specified correction window.

Surviving spouses have additional options when inheriting an IRA from a spouse. Depending on the circumstances, those options may include treating the IRA as their own or maintaining it as an inherited IRA. The 10-year framework should therefore not be presented as applying identically to every beneficiary.

Inherited Roth IRAs have different income-tax characteristics. Although a 10-year rule may apply, Roth beneficiary distribution requirements differ from those governing inherited traditional IRAs. The tax treatment of distributions can also depend on whether the applicable holding-period requirements have been satisfied.

For traditional accounts, the distribution period can create a tax-planning question. Depending on the beneficiary’s circumstances, taking different distribution amounts in lower-income and higher-income years can change the overall tax consequences.

Two time-sensitive considerations deserve particular attention.

• The year-of-death RMD. If the person who died was required to take an RMD for the year and had not completed it before death, the beneficiary may need to satisfy the remaining year-of-death distribution requirement. The specific deadline and responsibility should be confirmed based on the account and beneficiary’s circumstances.
• The nine-month qualified-disclaimer window. Federal tax law generally requires a qualified disclaimer to be made within nine months of the transfer that created the interest, subject to specific statutory requirements. A person considering a disclaimer should avoid assuming they can accept or control an inherited asset first and disclaim it later.

A person making a qualified disclaimer also generally cannot use the disclaimer simply to choose a new recipient. Instead, the property passes under the governing beneficiary designation, estate plan, or applicable law. Because disclaimers involve legal and tax requirements, evaluate them with appropriate legal and tax counsel before taking action.

These are not necessarily the only deadlines associated with an inheritance. Estate-tax returns, tax elections, retirement-account elections, valuations, probate requirements, and state-law deadlines may also apply.

Questions about how inherited retirement accounts fit into your financial plan? Book an intro call with a Brighton Jones advisor.

What actually decides where the money goes

Much of what happens to an inheritance may be determined before anyone reads the will. Trusts, beneficiary designations, account titling, and the age and structure of the estate plan can all influence where assets ultimately go. This is where estate planning and tax planning often have to work together.

Trust protection and trust tax brackets

Certain properly structured irrevocable trusts may provide creditor protection, depending on the trust terms, beneficiary rights, governing law, and specific circumstances. A standard revocable living trust generally does not provide the grantor the same type of creditor protection during the grantor’s lifetime.

Trust income-tax brackets are also compressed relative to individual brackets, which can make the decision to retain or distribute income an important tax consideration. Applicable thresholds are indexed and can change from year to year. Income distributed to beneficiaries may instead carry out taxable income to them, subject to the trust’s terms and applicable tax rules.

There’s also the question of who administers the trust. Naming one sibling as trustee over the others places a family relationship inside a fiduciary role. Depending on the circumstances, families may consider an individual trustee, corporate trustee, or co-trustee structure.

In our work with multigenerational families, sudden wealth can create emotional challenges, including uncertainty about the money and what it means for the family. Families may find it useful to pair estate structures with family conversations about the purpose and responsibilities associated with inherited wealth.

Beneficiary forms and plans that go stale

Beneficiary designations and account titling can control the disposition of many assets outside a will. For example, assets with valid beneficiary designations may pass directly to the named beneficiary, while jointly owned assets may pass according to the applicable form of ownership and state law.

Estate documents also reflect the family circumstances and tax law that existed when they were created. Changes in either can warrant another look at the plan.

For plans written before the SECURE Act and subsequent retirement-law changes, older trust provisions governing retirement accounts may produce results different from those originally anticipated. The treatment depends on the type of beneficiary and on whether the 10-year framework applies to many, but not all, inherited-account situations.

Liquidity matters as well. Federal estate-tax obligations can create a need for cash relatively soon after death. Certain estates holding qualifying closely held business interests may be eligible to defer estate-tax payments under Internal Revenue Code Section 6166, subject to detailed eligibility requirements.

Families below the federal estate-tax exemption may still face state estate or inheritance taxes, depending on the state involved.

Practical reasons to review an estate plan include marriage, divorce, births, deaths, moving to another state, selling a business, or a significant tax-law change. A review can include beneficiary designations and account titling as well as wills and trust documents.

Philanthropy as a tax strategy and a values strategy

Charitable giving can also interact with inheritance and income-tax planning.

Qualified charities generally do not pay income tax on amounts received from traditional retirement accounts. By contrast, taxable distributions of a traditional IRA to an individual beneficiary are generally included in that beneficiary’s income. Meanwhile, many capital assets held until death may qualify for a basis adjustment.

These differences can make the types of assets designated for charitable and individual beneficiaries an important estate-planning consideration. The most tax-efficient arrangement depends on the donor’s estate plan, assets, charitable goals, and beneficiaries.

For IRA owners age 70½ or older, a qualified charitable distribution, or QCD, can allow an eligible distribution to be made directly from an IRA to a qualifying charity and excluded from taxable income. An eligible QCD can also count toward an applicable RMD.

A donor-advised fund can offer another way to structure charitable gifts. Consider a hypothetical donor who normally gives $10,000 annually and instead contributes $50,000 to a donor-advised fund in one year, then recommends grants from the fund over the following five years.

The timing and amount of any charitable deduction depend on the donor’s circumstances and applicable tax rules. A charitable deduction generally requires the taxpayer to itemize, and contributions to a donor-advised fund are irrevocable. Donor-advised funds are not eligible recipients of qualified charitable distributions.

Bringing everything together

What we’ve found, working with families through some of the most disorienting moments of their lives, is that taking time to understand the inheritance can be an important first part of the planning process.

When inheritance tax planning and financial planning are coordinated, IRAs, basis, trusts, charitable giving, and the heir’s broader financial circumstances can be considered together. The appropriate approach depends on the assets involved, the governing estate documents, applicable federal and state law, and the beneficiary’s individual circumstances.

Frequently asked questions

What is the step-up in basis for inherited assets?

Many inherited capital assets generally receive a basis adjustment to fair market value as of the applicable valuation date, which can reduce capital gain when an asset is later sold. Important exceptions apply. Retirement accounts such as traditional IRAs generally don’t receive a basis adjustment, and taxable distributions are generally treated as ordinary income.

How long do I have to withdraw money from an inherited IRA?

Most non-spouse designated beneficiaries subject to the SECURE Act’s 10-year rule must empty the inherited account by the end of the applicable 10-year period. Some beneficiaries must also take annual distributions. Exceptions and different options may apply to surviving spouses, eligible designated beneficiaries, and certain other beneficiaries. Learn more about inherited IRA RMD rules.

Do I have to pay taxes on an inheritance?

There is no federal inheritance tax, but federal and state tax consequences can still arise depending on the assets and circumstances. For example, taxable distributions from an inherited traditional retirement account generally produce ordinary income, while appreciation occurring after the applicable basis valuation date can generate capital gain when an inherited asset is subsequently sold.

What is the nine-month disclaimer rule for inheritances?

A qualified disclaimer generally must satisfy federal tax-law requirements, including a nine-month deadline. A person who disclaims an asset generally cannot direct it to a recipient of their choosing. Because accepting benefits from inherited property can affect whether a disclaimer is available, legal and tax advice should be obtained before taking action.

Are trusts a good way to protect inherited wealth?

Certain properly structured irrevocable trusts may provide creditor protection depending on their terms, governing law, beneficiary rights, and other circumstances. Revocable living trusts generally do not provide the grantor equivalent protection during life. Trusts can also face compressed income-tax brackets, making distribution and tax planning important.

About the Author: Dan Moore, CFP®, is a Lead Advisor at Brighton Jones. He helps high-income professionals and families design tax-efficient investment strategies and retirement plans aligned with their principles and future objectives.

Disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Brighton Jones, LLC is neither a law firm nor a certified public accounting firm, and no portion of the blog content should be construed as legal or accounting advice. To the extent that you have any questions regarding the applicability of any specific issue discussed above to your individual situation, you are encouraged to consult with the professional advisor of your choosing.