Inheritance Tax Myths, Busted: What Millennial and Gen X Inheritors ACTUALLY need to know

Ever get that pit in your stomach thinking about the tax bill that might come with your inheritance? 

As both a financial advisor and an inheritor myself, I've been there.

In this episode, I'm breaking down exactly what you need to know about inheritance taxes. 

We'll cover when your inheritance is or isn't taxable, along with the taxes you'll need to watch out for in the decade after you inherit. 

Join me for a deep dive on the "step up in basis" and everything you need to know about the new tax rules for inherited IRAs.

Whether you've already inherited or are trying to build your knowledge for when you do, this episode of Heir Necessities has you covered. 

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Transcript

Understanding Inheritance Tax: A Complete Guide for Heirs

Introduction to Inheritance and Estate Planning

Katherine Fox (00:00) Hey, I'm Katherine and welcome to Heir Necessities, the podcast that turns complex financial concepts into real talk for generics, millennial, and gen Z inheritors. I'm a certified financial planner. I'm an inheritor myself, and I'm the founder of Sunny Branch Wealth, which is a fee only registered investment advisory firm that works exclusively with current and future inheritors. Every episode of Air Necessities, I break down a different topic related to generational wealth and inheritance and on today's episode, I am taking a deep dive into the taxes that inheritors need to understand.

It's not everyone's favorite topic, but it's something that's super, super important to have at least a basic understanding of So let's dive into it. The first thing that we wanna talk about taxes is understanding the taxes that you will pay as an inheritor versus the taxes that the estate you are inheriting from will pay.

The Difference Between Estate and Inheritor Tax Obligations

And this is a really important distinction. Sometimes it feels like it's not that important of a distinction because it kind of comes out in the wash, right? Like if the estate pays it, it reduces your inheritance. If you pay it, it reduces your inheritance. But there is a lot of like mental energy and stress associated with paying taxes. And so understanding what isn't, isn't your responsibility is really helpful.

Federal Estate Tax Explained: Thresholds and Exemptions

So let's start with a basic primer on estate taxes. Estate taxes are levied based on the value of a decedent. So the decedent is just a fancy way of saying a person who died. I'm gonna keep using it because it's an expeditious word. So estate taxes are levied on the total value of a decedent's estate. There are federal estate taxes and then several states, 12 states plus DC to be specific, also have state estate taxes. So right now, the federal estate tax is at a little over 13 million for an individual, so about 26 million for a married couple.

So most people won't have to deal with the federal estate tax unless their estate is greater than 13 million or 26 million if they're married. then on the state level, if the decedent lived or owned property in a state with an estate tax, then their estate is going to be responsible for paying that state tax.

State-Level Estate Taxes: Understanding Regional Differences

for example, I live in Oregon. The estate tax exemption here is a million dollars. So if I die and I am worth, you know, $4 million, say when I die, then $3 million of that, of my estate is going to be taxable, not at the federal level, remember, because you have that $13 million or $26 million exemption but at the state level here in Oregon.

But think about someone who lives in a state, say like Florida, that doesn't have an estate tax, but they also own like a $2 million beach house on the coast here in Oregon. They don't have to pay any estate tax on anything that they own in Florida, but that real property that's citised in Oregon, that exists in Oregon, is going to be subject to Oregon estate tax. so even if the person who died doesn't live in a state that has a state tax, if they owned a real property in a state with a state tax and that real property is valued at more than that state's estate tax exemption, then they still may have to pay an estate tax.

Executor Responsibilities and Estate Tax Management

But if you're not the executor of an estate, then you don't really need to worry about estate tax. You should know that it exists because it may reduce the value of what you're gonna get as an inheritor, but you don't actually have to interact with it. It's the responsibility of the person who's actually settling the estate to deal with the estate tax. There's also inheritance taxes. Now there's no federal inheritance tax, but there are six states that have inheritance taxes.

Understanding State Inheritance Taxes

And those inheritance taxes are based on where the decedent lived and owned property, again, just like a state tax, not where you live. So if you live in a state, say like Maryland, with an inheritance tax, but the person who died lived in Washington state, which doesn't have an inheritance tax, then you don't have to pay that inheritance tax. Again, it's not about where you lived it's about the place where the person who died lived.

And so you can flip that if the person who died lived in Maryland, but you live in Washington state, you may be responsible for paying that inheritance tax on assets you inherit because they came from a Maryland estate. Again, there only six states that have inheritance taxes. It's not super common, so it's not something that most people have to worry about in the same way that state estate tax is not something that most people have to worry about.

Estate Income Tax Requirements

Before we jump into the part that most people are actually gonna care about, which is like, taxes do I actually have to pay? Okay, I don't have to worry about the state tax. You said I probably don't have to worry about inheritance tax depending on where I live. Like then what do I actually have to worry about? I also wanna know that estates also have to pay their own income tax. So if someone dies, say they have a taxable estate that's worth like $15 million that estate is going to be generating income, like the assets in that estate, whether it's rental property or investments or whatever, those assets are going to be generating income and the estate itself has to pay taxes and file a tax return on that income.

And so I just wanna flag that for anyone who's out there listening to this and is an executor of an estate flagging the fact that not only do you have to file the decedent's final income tax return for themselves, you may also have to file an income tax return for the estate itself. Again, if you're just inheriting, you're not an executor or anything of an estate, you don't need to worry about that. But since this is a podcast episode about taxes, we're going to talk about the taxes also that an estate itself needs to pay.

What Inheritors Need to Know About Taxation

Okay, so now we are diving into the meat of the thing and what most people actually want to know. It only took me like half the episode to get into it, which is what taxes are you going to pay as an inheritor? And this is something that is really difficult a lot of times for people to understand. So I just, want to start by saying it very slowly and very clearly. Inheriting itself is not a taxable event. So if you inherit $5 million from an estate, the act of transferring that money from the estate to you is not taxable.

Tax-Free Asset Transfers in Inheritance

Okay? You are not going to owe any money in taxes simply because you inherited assets and they moved over into your own name. Now that being said, depending on the assets that you inherited and what you plan to do with them, there may be taxes that follow after you receive your inheritance. But I just want to be very, very clear because this is something that's confusing to a lot of people because in the vast majority of cases when you get income, right, you have to pay taxes on that income. An inheritance is a transfer. Money moves from one person to you. And if it's just a straight transfer of assets you are not going to owe taxes on that.

Now, if assets were in your name and were sold and then the cash was transferred to you, that's a different story. But I'm literally just talking about, again, like you receive a distribution from an inheritance or a straight transfer over of assets or an account moves from the decedent's name into your name, that is not a taxable event. But the tax treatment of inherited assets, so once they're in your name the tax treatment kind of goes like a little bit wild depending on what that asset is.

Step-Up in Basis: A Key Tax Benefit for Inheritors

So once these assets are in your name, let's talk about what taxes you can expect. So the first thing to talk about here is called the step up in basis. And it's probably something that you've heard about before. Basically, when someone dies, the majority of their assets are going to receive a step up in basis. And what that means is that the cost basis of that asset is equal to its value on the day that person died.

Example: How Step-Up in Basis Works with Stocks

let me give an example to explain what that actually means. so if, 40 years ago I bought a of Microsoft stock for a dollar and I've just been holding that share of Microsoft stock, it's split a couple times, whatever. Now, the value of my holding in Microsoft is, call it $100,000. This isn't necessarily supposed to be a realistic example. So I bought my share of Microsoft for a dollar, now it's worth $100,000.

If I wanted to sell my Microsoft position for $100,000, I would owe tax on $999,999 of unrealized capital gain because my cost basis is a dollar, which is what I purchased it for, and my current value is $100,000. So basically on all of that $100,000 minus $1, that would all be taxable if I sold it while I was alive.

But instead, if I died holding onto that stock and then I turned around and gifted it to one of my heirs, that heir would get a step up in basis. So now instead of inheriting my $1 cost basis, that person has a new cost basis, which is equal to the value of that stock on the day I died. So my heir's cost basis is $100,000, which was the value of that stock on the day I died. So if then my heir wants to turn around and sell all that Microsoft, it's still worth $100,000, they don't owe any taxes.

Tax Benefits and Limitations of Step-Up in Basis

So this is a huge, huge tax benefit that again, disproportionately benefits wealthy people who are the people who own assets, but it can apply to everyone. So the step up in basis, what that means is that if you inherit assets through just a regular taxable account and then you wanna sell those assets, depending on what their value has done between when the person died and when you actually got access to them or want to sell, you could be owing little to no tax on the sale of those assets, which is great.

The trick to this is that not all assets get a step up in basis. So if you inherit assets that were in an irrevocable trust before someone died and then they passed through to you, assets held within and irrevocable trust do not get a step up in basis. So just because you inherited securities, you shouldn't assume that they get a step up in basis. You should always check with the estate executor, the CPA, or the attorney to make sure of what the cost basis is before you move forward with any sales.

Inherited IRA Accounts: Special Tax Considerations

The second piece of taxes and inheriting that usually trips people up is inherited IRA accounts. And I have so many blog posts about this, a whole episode of Air Necessities about this. So if you're interested in learning more about this, this is going to be a very brief overview, but I do have more deep dive content. I'll put links to that in the show notes.

If you inherit a taxable IRA or 401k account, every dollar that you pull out of that account is taxable income. So if you inherit a million dollar IRA, the step up in basis doesn't matter. If you pull $100,000 out of that IRA, that $100,000 is taxable income to you. And in the vast majority of cases, you are going to be required to fully empty that million dollar IRA account within the 10 years after the date of death of the person who died.

Tax Implications of Inherited Retirement Accounts

So inherited retirement accounts are actually the single biggest tax issue that inheritors face. And it's compounded because most people save in retirement accounts, which means most people are going to inherit taxable retirement accounts. because there was a big change about these requirements, about how you have to take money out after you inherit a taxable retirement account, it's a huge tax burden that most inheritors don't realize they're facing.

Conclusion: Key Points About Inheritance Taxes

There are other taxes that you might have to worry about after you inherit. Like if you inherit property, you're going to have to worry about, you know, like the taxes on the income coming off that property. But broad strokes, the two most important things to know about the taxes after you inherit are to check if you've got a step-up basis and if you did, understanding that you may be able to sell those positions with little to no tax impact, and then to understand the tax implications of any inherited taxable retirement accounts that you received as part of your overall inheritance.

If you have any more questions about taxes and inheritances, this has been a really down and dirty look. I'll drop links to other content I've created that's focused on this topic. You can always feel free to send me an email, send me a DM on Instagram. I'll drop all my contact information in the show notes too. And until then, I'll look forward to chatting on the next episode of Your Necessities.