We answer a lot of questions about taxes on inheritances, and it makes sense to assume that people that received bequests must claim them as taxable income. In reality, there is surprisingly good news to share on this front. Inheritances are not subject to regular income taxes, and this would include life insurance proceeds.
Another thing to know about inherited assets is the concept of the step up in basis. If someone leaves you an asset that appreciated during their lifetime, you would not have to pay the capital gains tax on the appreciation. You would however be responsible for future gains if you hold on to the assets and sell them at some point in the future.
Since we are on the topic of taxation, we should briefly touch on the potential for estate tax exposure. Very few families have to be concerned about the federal estate tax, because it only applies on transfers that exceed $11.4 million. This is the exclusion in 2019, and there are relatively modest annual adjustments to account for inflation.
There are some states that have state-level estate taxes, and the exclusions are typically lower than the federal exclusion. Fortunately, here in Ohio where we practice law, there is no state-level estate tax.
Individual Retirement Accounts
Now that we have provided a bit of a basic framework, we can move on to the subject of this particular blog post.
There are essentially two different types of individual retirement accounts that are typically utilized: traditional IRAs, and Roth individual retirement accounts.
You contribute money into a traditional IRA before you pay taxes on the income. This gives you a benefit in the immediate term, because this reduces the amount of your taxable income.
However, because of this arrangement, withdrawals from the account would be subject to regular income taxes. You can start to take money out of the account without being penalized when you are 59.5 years of age, but there are a few exceptions.
An account holder can take some money out of the account to help facilitate a first home purchase, and withdrawals are permissible for unpaid medical expenses and school tuition.
From an estate planning perspective, you cannot leave the money in the account indefinitely without touching it with your legacy in mind. When you are 70.5 years old, you are required to accept mandatory minimum distributions.
A beneficiary that is anyone other than your spouse would also be required to take mandatory minimum distributions after your passing, and they would be taxed. Since the tax-deferred growth is a benefit, it would be wise for the beneficiary to take only the minimum that is required.
From a tax perspective, the dynamic is reversed with a Roth individual retirement account. Contributions into the account are made after taxes have been paid, so there are no taxes to pay when and if money is withdrawn.
The reason why we included the word “if” is because you are never required to accept distributions from a Roth IRA, because you already paid the necessary taxes. This is also the case when the beneficiary assumes ownership of the account after you are gone.
Once again, the beneficiary would do well to stretch the individual retirement account by accepting only the required minimum distributions to take maximum advantage of the tax situation.
We Are Here to Help!
Our doors are open if you would like to discuss your estate planning objectives with a licensed attorney. You can send us a message through our contact page to request an appointment, and we can be reached by phone at 513-721-1513.