Inheritance

An inheritance is property or money a person receives because someone died. The word covers everything that arrives by that route, whatever the mechanism: a share of an estate under a will, a payout named on a beneficiary form, a bank account that passed automatically to a surviving joint owner, a distribution from a trust, or a share fixed by state law where there was no will at all.

For the person receiving it, the federal answer is short. Section 102(a) of the Internal Revenue Code provides that "gross income does not include the value of property acquired by gift, bequest, devise, or inheritance," so receiving an inheritance is not a taxable event and produces no entry on a tax return. The questions worth attention are the ones that follow: what the property's cost basis now is, what tax the income it generates will attract, and whether the particular asset carries withdrawal deadlines of its own.

Not income, but its income is income. Section 102(b) carves the earnings out of the exclusion in two ways. The income produced by inherited property is taxable, and a bequest that consists of the income from property rather than the property itself is taxable too. So the house arrives untaxed and its rent is reportable from the first month; the portfolio arrives untaxed and its dividends are reportable from the first quarter. Where an estate or trust distributes income to a beneficiary during administration, that income is generally taxed to the beneficiary rather than to the estate, which is why a Schedule K-1 sometimes turns up in the year after a death for someone who was told there would be no tax.

Basis resets, and this is the rule that decides the arithmetic. Under section 1014 the basis of inherited property is generally its fair market value at the date of death, so decades of unrealized appreciation disappear for income tax purposes. The reset is mandatory rather than favorable, which means it works in both directions: an asset worth less than the deceased paid for it is stepped down, and the loss is lost. Two categories are outside it and both are common. Retirement accounts get no reset, because section 1014(c) excludes property that is a right to receive income in respect of a decedent. And in community property states both halves of community property are revalued rather than only the deceased spouse's half, which is a large difference for a surviving spouse.

Retirement accounts are a different animal, and the pre-tax and Roth answers are not the same. An inherited traditional IRA or 401(k) balance is taxed as ordinary income as it comes out, because nothing in it was ever taxed. An inherited Roth account generally comes out free of income tax. Both are on a clock: most beneficiaries have to empty the account within ten years, and in some cases must take something out in each of the intervening years as well. Never treat "inherited retirement account" as one thing; the deadline applies to both and the tax applies to one.

The tax on the estate and the tax on the recipient are two different taxes. The federal estate tax is imposed on the transfer and paid by the executor out of the estate, and because each person can pass a very large amount free of it, it reaches a small share of estates. Separately, a minority of states impose an inheritance tax, which falls on the person receiving the property and is rated by relationship to the deceased. Two points are routinely stated wrongly. A state can levy an estate tax and an inheritance tax, so "some states tax the estate and others tax the recipient instead" is not a reliable taxonomy. And a child is not automatically exempt from a state inheritance tax: at least one state taxes direct descendants at a positive rate while exempting a surviving spouse. State thresholds can also sit far below the federal exclusion, so a family well clear of federal estate tax can still meet a state one.

Why some assets arrive quickly and others take a year. Property leaves a deceased person's hands by one of four routes, and only the last of them involves the court. A beneficiary designation on a retirement account or life insurance policy pays the named person directly and overrides the will. Titling with a right of survivorship, or a payable-on-death registration, transfers by operation of the account agreement. Property already inside a funded trust is distributed under the trust's own terms. Everything left over passes under the will, or under the state's intestacy statute if there is no valid will, and that is the part that goes through probate, waits out a creditor claim period, and takes months. A beneficiary who receives one asset in three weeks and another eleven months later is not being treated inconsistently; the two assets traveled by different channels.

The words "heir" and "beneficiary" are not interchangeable in law, even though they are used loosely in conversation. Under the Uniform Probate Code an heir is a person entitled to take under the intestacy statute, and a beneficiary is a person named in an instrument. Someone can be one without being the other, and where a will exists it is the instrument rather than the intestacy statute that controls.

The sequence a recipient actually experiences.

1. The assets are sorted by transfer channel. Beneficiary designations, survivorship titles and funded trusts pay out without waiting for the court. Everything else forms the probate estate.

2. The estate settles its own obligations. Debts, final income tax, and federal estate tax where it applies are paid by the estate before anything is distributed. The recipient is not personally liable for these.

3. The recipient receives the property, and reports nothing. Section 102(a) keeps it out of gross income.

4. Basis is established at the date-of-death value. This is the figure the recipient will subtract from a future sale price, so it is worth documenting at the time rather than reconstructing later.

5. Income and deadlines begin. Rent, dividends and interest are now the recipient's taxable income. If a retirement account was inherited, its withdrawal clock has started.

A hypothetical example of why the basis reset matters more than the estate tax for most families. Ana inherits her father's stock, which he bought for $40,000 and which is worth $260,000 on the day he dies. The estate is far below the federal exclusion, so no estate tax is due. Ana's basis is $260,000. She sells six months later for $272,000 and reports a $12,000 gain. Had her father given her the same shares during his life, her basis would have been his $40,000 and the same sale would have produced a $232,000 gain.

Pros

• Not taxable income to the recipient, with nothing to report on receipt.
• The basis reset at death wipes out income tax on gain accumulated during the previous owner's lifetime, which is one of the most valuable rules in the code for families passing down appreciated assets.
• Federal estate tax, where it applies, is the estate's obligation rather than the recipient's.
• Assets that passed by beneficiary designation or survivorship arrive without waiting for probate to finish.

Cons

• The income the property generates is taxable from the moment it is yours, which surprises people who were told an inheritance is tax-free.
• Inherited retirement accounts carry withdrawal deadlines, and a pre-tax account is taxed as ordinary income on the way out.
• A minority of states tax the recipient directly, at a rate that depends on relationship, and a child is not automatically exempt.
• Receiving an inheritance outright can disqualify someone who relies on income-tested or asset-tested benefits.
• The reset works downward too: an asset that lost value has its basis stepped down, and the loss cannot be claimed by anyone.