It might seem like the Internal Revenue Service wants its percentage every time money changes hands, but this isn't quite the case. Inheritances are not considered income and they aren't taxed as such. This isn't to say that no taxes will ever come due on inherited assets, however. Several things can change their status and bring the tax man to your door.
You won't owe income tax if your beloved uncle dies and leaves you money he kept in a savings account. If he leaves you $300,000, it's yours free and clear – your uncle already paid taxes on it once when he earned it. The IRS places no limits on how much you can inherit. If you take the cash and place it in a coffee can in your backyard or somewhere else where it never grows or earns any interest, you'll never owe the IRS a dime. But if you move it into a savings account of your own and it begins earning you interest, the interest is taxable to you as income.
Inheritance Tax vs. Income Tax
Although you don't have to pay income tax on your inheritance, you may have to pay other taxes. Six states impose an inheritance tax as of publication: Nebraska, Iowa, Kentucky , Pennsylvania, New Jersey and Maryland. Sometimes the estate will step in and pay this tax for the beneficiary, but this decision is left to the executor – it typically isn't covered by state law, and there's no tax requirement that the executor must do so. If you're closely related to the deceased, you might avoid this tax; at the very least, it can be minimal. Spouses can usually inherit tax-free, and other immediate kin usually pay a reduced percentage from what might be owed if the deceased's neighbor or best friend inherited from him.
Don't confuse inheritance tax with the estate tax -- they're two different things. Estate tax is based on the total value of the deceased's estate, and it's payable by the estate, not its beneficiaries. It's imposed at the federal level and in some states. It doesn't kick in at the federal level until the value of an estate exceeds a certain amount -- $5.43 million at publication -- and only the balance over this threshold is taxed.
Life Insurance Death Benefits
You most likely won't owe any taxes if the deceased named you as the beneficiary of his life insurance policy. If you inherit death benefits, they're not considered income unless he sold you the policy before he died or you receive the benefits in installments. If you bought the policy, the entire proceeds are taxable to you -- you own it. If you take the proceeds in installments so the bulk of the money remains with the insurer for a period of time and earns interest, the interest is taxable. The same applies if you take the proceeds in one lump sum and deposit the money in a bank account or invest it – its earnings are then taxable just as if you'd done the same with a cash inheritance.
Inheritance of Property
If you inherit real estate property rather than cash, you may end up owing capital gains tax if you ever decide to sell it. The property's basis is typically its value on the date of death, but the executor can elect another date for estate tax purposes. Even so, the date usually isn't years apart from the date of death. If your uncle left you his house and you turn around and sell the property a few months later, you would have a capital gain if the sales price is more than the date-of-death value or the value on the date selected by the executor. But it's a long-term gain subject to capital gains tax rates, not tax brackets for ordinary income, which can be higher. This is the case even if you don't hold the property for a year or longer, the rule for real property that's not inherited.
Inherited retirement funds are subject to a whole host of tax rules all their own. If you’ve inherited an IRA, 401(k) or pension, your best bet may be to touch base with a tax professional and find out where you stand. If you take distributions, they’re normally taxed as income, just as they would be if the deceased had taken the distributions himself. This depends on whether contributions to the account were made with pretax dollars or the deceased took a tax deduction for the contributions. You may need the advice of an accountant to determine this. You might be able to avoid a tax hit if you inherit a Roth plan. A tax professional can tell you for sure.