Leaving Or Getting An Inheritance – There Are Tax Implications.

The question:   “I received an inheritance, how is that going to impact my taxes?”

My response – “It depends.”  Here is the jest of the conversation as we unpack the situation.

Look at the type of asset, ownership at death and state laws.

Type of Asset:

Non-retirement assets such as real estate, brokerage accounts, artwork or collectables generally receive a step up in cost basis.  The IRS allows heirs to reduce or eliminate the tax on the growth of an asset.  For example: a portfolio was purchased in 2003 for $100,000 (original basis).  At death, the portfolio was worth $400,000.  The heir would get a new basis of $400,000.  If they immediately sold the stock, there would be no capital gain tax.  If the stock continued to climb to $500,000 then sold, the heir would only pay gain on the $100,000. You have six months to proactively make the calculation as it doesn’t happen automatically.  If real estate or artwork, an appraiser needs to be brought in. With investment assets, fair market value can be established on the date of death, or when assets are transferred to new owner.  There are taxation reasons to look at this window carefully and discuss with your financial professionals.

Retirement accounts, annuities and pensions do not receive the adjustment to basis.  With the 2019 Secure Act, the stretch IRA is dead and most non-spouse beneficiaries have only ten years to take the assets out and pay ordinary income tax on distributions.  If you own assets in these types of accounts, it is important that you consider your heirs and how inheriting these types of assets will impact them.  If you are an heir, you can be very strategic in how to take money out of these tax-sheltered accounts based on your taxable income and time frame for needed cash flow.

If you are the beneficiary of a life insurance policy, cost basis is not a consideration.  You will not pay any income taxes on the death proceeds.  If the proceeds sit in an income-bearing account prior to receipt, you do need to report interest on your tax return.  A common mistake is to name your estate as the beneficiary of your life insurance proceeds.  You have missed the opportunity to pass along this asset to a real person and subject the contract to the probate process.  If you own a life insurance contract, the death benefit will also increase the size of your estate and subject your heirs to estate taxes (current exemption is 11.7 million).  Is it time you review your insurance contracts to make sure they are working as you intend?

Ownership:

When an asset is owned by the decedent or held in a revocable (living) trust, they will get the step-up benefit.  If the asset is owned jointly or in a joint trust with a spouse, one-half of the assets are eligible. With brokerage accounts, be cautious if spouses have different last names and contact the custodian to make sure they have a copy of the death certificate.  They will update the cost basis for ½ the account per direction of you and your financial advisor.  When assets are owned in an irrevocable trust, there is no opportunity for a step up as the assets are outside of the decedents’ estate.

State laws:

If you live in a community property state, as a surviving spouse, you will enjoy a step up in basis to both you and your spouse’s ownership portions.  Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.  While Colorado is not a community property state, you may own property in a community property state and consider residency for estate planning purposes.

All this may change and there are nuances.  Although there were proposals in Congress to change aspects of the step-up laws, they did not pass in 2021.  Colorado tax laws have a different take on cost basis.  As we know, nothing is set in stone – so stay tuned and plan accordingly.  Work with your financial professionals to be pro-active with your estate planning and consider how the cost basis environment may impact you. Prepare and educate your heirs knowing that your financial assets are just one aspect of the legacy you want to pass on to those you love.