Minimizing Taxes on Inherited Wealth
While inheriting wealth is a blessing, there is also responsibility that comes along with it. Generational wealth transfer involves planning and strategy from all parties involved. Depending on the type of asset and your location, you might face estate taxes, income taxes, or capital gains taxes with inherited wealth. However, with the right strategies, it is possible to minimize the tax burden and preserve more of your inherited wealth.
Understanding the Types of Taxes That May Apply
The first step to creating an effective strategy is to understand the types of taxes that can affect your inherited wealth.
Estate Taxes
The federal government imposes an estate tax on estates exceeding a certain amount. The amount depends on things like marital status or your location and is subject to change. It is important to keep up with current estate-tax thresholds.
Income Taxes
Generally, you do not pay income tax on money or property that you inherit. However, some inherited assets such as traditional IRAs, 401(k)s, and annuities can trigger income taxes when distributions are taken.
Capital Gains Taxes
If you sell inherited property such as a home or stocks, you may be subject to capital gains tax on the appreciation amount. Some of this can be reduced through the step-up in basis rule, which we discuss below.
The Step-Up in Basis Rule
One of the most valuable tax benefits for heirs is the step-up in basis. When assets are inherited, cost is adjusted to its fair market value at the date of death. This means that if you sell an asset shortly after inheriting it, you may owe little or no capital gains tax.
Be Strategic With Inherited Retirement Accounts
Inherited retirement accounts are taxed differently depending on the account type and your relationship to the original owner.
Traditional IRAs and 401(k)s
Traditional IRAs and 401(k) accounts are tax-deferred. This means income taxes will be owed upon withdrawals. Under the SECURE Act, most non-spouse beneficiaries must fully withdraw the account within 10 years, which can create a substantial tax hit if not planned carefully.
Roth IRAs
Inherited Roth IRAs are typically tax-free if the account has been open for at a minimum of 5 years. Withdrawals from Roth IRAs are still subject to the 10-year rule, but no income tax is owed.
Qualified Charitable Distributions (QCDs)
Making QCDs from an inherited retirement account can reduce taxable distributions. This is especially effective if the original owner of the account was already subject to required minimum distributions.
Use Trusts to Protect and Direct Inherited Wealth
Trusts can be powerful tools for directing, protecting, and minimizing taxes on inherited wealth. Depending on the structure, trusts can aid in avoiding probate, minimizing estate taxes, providing creditor protection, and directing how and when assets are distributed to beneficiaries. Trusts can be complex. Consult with an estate attorney to design one that aligns with your goals.
Work With Professionals
Inherited wealth often comes with emotional and financial complexity. Your financial advisor is here to help make the process as smooth as possible. Your financial advisor can partner with an estate attorney and a tax professional to create a strategy that aligns with your unique values and goals.