Why Is It Important to Know the Tax Implications of an Inheritance?

Receiving an inheritance can be a significant life event, often bringing with it a mix of emotions and financial considerations. Understanding the tax implications is crucial for managing inherited wealth effectively. Navigating these complexities can help beneficiaries avoid unexpected liabilities and ensure the inheritance serves its intended purpose.

Federal Estate Tax Implications

The federal estate tax is a levy on a deceased person’s right to transfer property at death, rather than a tax on the inheritance received by beneficiaries. This tax applies only to very large estates, as there is a high exemption threshold. For 2025, the federal estate tax exemption is $13.99 million per individual, meaning a married couple can shield up to $27.98 million from this tax. Only the portion of an estate exceeding this exemption amount is subject to the federal estate tax, which can have a top marginal rate of 40%.

The responsibility for paying federal estate tax generally falls on the deceased’s estate itself, specifically the executor, before assets are distributed to heirs. An estate tax return, Form 706, must be filed within nine months of the person’s death. Even with the high exemption, understanding the federal estate tax is important for estate planning, especially for those with significant assets or who may serve as an executor.

State Inheritance and Estate Tax Implications

Beyond federal considerations, some states impose their own taxes on wealth transfer at death, which can be either an estate tax or an inheritance tax. A state estate tax functions similarly to the federal version, taxing the deceased’s estate before distributions. Conversely, an inheritance tax is levied directly on the beneficiary who receives inherited assets, with tax rates often varying based on the beneficiary’s relationship to the deceased.

Not all states levy these taxes, and the rules, exemption amounts, and rates vary significantly among those that do. As of 2025, some states impose estate taxes, while others levy inheritance taxes. Maryland is unique in that it imposes both an estate tax and an inheritance tax.

The specific state where the deceased resided, or where inherited property is located, determines which state-level taxes may apply. Some states offer exemptions for certain beneficiaries, such as spouses or direct lineal descendants, reducing or eliminating their inheritance tax liability. Therefore, it is important to research the specific tax laws of the relevant state to understand potential obligations.

Income Tax Implications for Beneficiaries

While most direct inheritances, such as cash or real estate, are not considered taxable income to the beneficiary, certain types of inherited assets can trigger income tax upon distribution or withdrawal. This distinction is particularly relevant for inherited retirement accounts, which were designed to be tax-deferred. Distributions from inherited traditional IRAs and 401(k)s are taxed as ordinary income to the beneficiary because the original contributions or earnings grew tax-free.

The SECURE Act altered the rules for non-spouse beneficiaries of inherited retirement accounts, requiring the entire account to be distributed within 10 years of the original owner’s death. This accelerated distribution schedule can push beneficiaries into higher income tax brackets. Spouses, however, have more flexibility, including the option to roll the inherited assets into their own retirement accounts, thereby deferring taxes.

Other assets, such as inherited savings bonds, also have income tax implications for beneficiaries. The interest accumulated on these bonds, both before and after the original owner’s death, is taxable as ordinary income when the bonds are redeemed. Beneficiaries may choose to pay the tax on accrued interest at the time of inheritance or defer it until the bonds are cashed in or mature.

Understanding Basis and Capital Gains on Inherited Property

When inheriting capital assets like real estate, stocks, or other investments, understanding the concept of “basis” is important for future capital gains tax calculations. The cost basis of an asset is its value for tax purposes, used to determine capital gains or losses when the asset is sold. For inherited property, the “step-up in basis” rule applies. This rule adjusts the asset’s cost basis to its fair market value on the date of the deceased’s death.

For example, if an asset was purchased years ago for a low price but appreciated significantly by the time of the owner’s death, the beneficiary’s basis becomes that higher fair market value. This step-up eliminates any capital gains tax on the appreciation that occurred during the original owner’s lifetime if the asset is sold soon after inheritance. If the asset is held longer and continues to appreciate, capital gains tax would only apply to the increase in value from the date of death to the sale date.

In some cases, an “alternate valuation date” can be elected, allowing the estate to value assets six months after the date of death if the asset values have decreased, potentially reducing estate tax liability. However, this election must reduce both the value of the gross estate and the federal estate tax due. Knowing the correct basis is important for accurately calculating any future capital gains or losses and for proper tax reporting.