The passing of a loved one is, of course, always a difficult period. A large part of my team’s practice is helping clients prepare their estate planning as well as helping families after someone has passed away.
The tax rules regarding inherited money can be a bit confusing, and I think with some simple planning and family communication taxes at the time of death of a parent or grandparent can be effectively managed in today’s estate tax environment.
First, when discussing this topic in Indiana, there are a couple of key points to understand. Indiana does not currently have an inheritance tax. The inheritance tax in Indiana was repealed in 2013. So, if assets are inherited from an Indiana resident the state does not levy a tax.
The federal government does have an estate tax, but it applies only to estates above $11.7 million of assets in 2021. This $11.7 million is called the Estate Tax Exemption and it is estimated the federal estate tax at this level will apply to only 0.2% of American households (source: CNBC). While federal estate tax rates can be extremely high and burdensome when they do apply, federal estate taxes are simply not a planning concern of most families in America.
So long story short, if assets are inherited from someone in Indiana, inheritance and estate taxes are not likely to be relevant. But that doesn’t necessarily mean there won’t be taxes to pay.
The type of asset or account inherited also affects the tax treatment of the inheritance. In my experience there are a few different types of financial assets that can be inherited, and each type has a different tax treatment.
Let’s start with cash, which we will consider to include checking accounts, savings accounts, CDs and money market funds. This one is straight forward. Unless the estate exceeds the $11.7 million discussed above, these accounts are not taxed.
Moving on to stocks and mutual funds. Because these types of investments incur capital gains tax when they are sold, each investment is considered to have a purchase price or basis. The capital gains tax applies to the value of the investment in excess of the basis. For example, buy a stock for $100, sell it for $200 and taxes will be due on the $100 of gain.
When however, a stock or mutual fund is inherited, the basis on the investment steps up or resets to the value on the date of death of the original owner. For example, if a parent bought a stock 40 years ago for $10,000 and held it to pass on to an heir at the value of $50,000, the heir now only pays capital gains tax on the amount the stock is sold for over $50,000. These rules also apply to inherited real estate such as houses and farmland, as well as items such as collectables or vehicles. So, in my experience with most market environments and with most estates, capital gains taxes end up being nominal.
Non-qualified annuities are also a commonly inherited asset. Annuities accumulate growth and earnings in a tax-deferred manner for the annuity owner. This means if interest or gains in the annuity are not withdrawn from the annuity, the gains are not taxed. When funds are withdrawn from an annuity, the funds are considered to be withdrawn gain first, and upon the withdrawal the gains are taxed as ordinary income, not capital gains.
While gains in annuity are tax deferred, they are not however tax free, and when the annuity is passed to a beneficiary or heir the tax comes due. Annuities do not receive the step up in basis, if the annuity has gains the beneficiary must pay taxes on the gains when the annuity is inherited. The gains are taxed as income to the beneficiary, but the original deposit or basis of the annuity is not taxed. For example, if the parent purchased an annuity 20 years ago for $20,000 and the annuity grew to $50,000 the beneficiary would pay taxes on $30,000, the original $20,000 investment would not be taxed.
With extremely rare exceptions, life insurance proceeds are almost always received income tax free.
IRAs, 401(k)s and other employment related retirement plans are typically taxed as income, and the manner of the taxation is its own column.
So while it is unusual to have to pay federal estate taxes and there is no inheritance tax in Indiana, most estates do involve some form of taxes and so it is best to seek qualified tax and financial advice to make sure the taxes are understood, planned for and ultimately paid in a timely manner.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.
