Understanding Inheritance Taxes: What You and Your Beneficiaries Need to Know

When planning for your death, there’s one issue you may not have thought about, but is so important to your beneficiaries: will your loved ones have to pay taxes on what you leave them? The answer isn't straightforward because it depends largely on the types of assets you're passing down, how much you are passing on, and where you reside at the time of your death. Understanding how different accounts and assets are taxed can help you make informed decisions that minimize the tax burden on your beneficiaries.

In this article, I'll break down the tax implications of various types of inheritance, from cash accounts to retirement plans, so you can plan strategically and protect more of your wealth for the people you love.

Estate Taxes: Will They Apply?

There are three things we’ll never know about you, no matter how much planning we do now, and how proactive we are about your future planning: when you’ll die, what your assets will be when you die, and what the federal estate tax exemption amount will be when you die. Over the past 25 years, the federal estate tax exemption has been as low as $675,000 and, today, as high as $15,000,000 per person.

This means that in  2026, the federal estate tax only applies to estates exceeding $15 million for individuals or $30 million for married couples. If your estate falls below this amount, your estate won't pay federal estate taxes. If your estate’s value exceeds the exemption, taxes will need to be paid before beneficiaries receive their distributions. And, if you are married, it’s critically important that estate planning is reviewed and updated after the death of the first spouse to use and preserve the full estate tax exemption of the first spouse.

Also know that some states impose their own estate or inheritance taxes with much lower exemption amounts. Understanding both federal and state requirements is crucial for comprehensive planning.

Finally, note that estate tax, income tax, and capital gains tax all matter when we’re talking about inheritance (trust taxes may apply, too, but for the sake of brevity, I’ll discuss trust taxes in a future article). Even though you’re planning for your death, there is much more to consider than the federal or state estate tax. You need to also create a strategy for each type of asset you own.

With this framework in mind, let's explore how different types of assets are taxed when your loved ones inherit from you.

Cash and Bank Accounts: The Simple Answer

When your beneficiaries inherit cash from checking accounts, savings accounts, or money market accounts, they receive favorable tax treatment. If you leave someone $50,000 in your savings account, they receive the full $50,000 without federal income tax consequences.

There's one small exception to note. If your account earns interest after your death but before distribution, that interest becomes taxable income to the beneficiary. However, the principal amount itself remains tax-free.

This straightforward treatment makes cash accounts one of the most tax-efficient assets to inherit, which is why many estate plans include liquid assets alongside other investments.

Investment Accounts: The Step-Up in Basis Advantage

Taxable investment accounts, including brokerage accounts holding stocks, bonds, or mutual funds, benefit from what's called a "step-up in basis." This tax provision can save your beneficiaries a significant amount of money.

Here's how it works. When you purchase an investment, your "basis" is typically what you paid for it. If you bought stock for $10,000 and it grew to $100,000, you'd normally owe capital gains tax on that $90,000 gain if you sold it. However, when your beneficiaries inherit that stock, their basis "steps up" to the fair market value at your death, which is $100,000 in this example. If they immediately sell it for $100,000, they owe no capital gains tax at all. However, if they sell it later and the stock has appreciated, they will owe capital gains tax - but only on the amount above $100,000.

This step-up in basis is one of the most powerful tax benefits in estate planning, effectively erasing all capital gains that accumulated during your lifetime. Your beneficiaries only pay capital gains tax on appreciation that occurs after they inherit the asset.

Understanding this benefit can influence your gifting strategy. Sometimes it's more tax-efficient to hold appreciated assets until death rather than gifting them during your lifetime, when the recipient would inherit your lower basis, and therefore pay taxes on capital gains incurred via a sale after the gift of the asset.

Retirement Accounts: A More Complex Picture

Retirement accounts like 401(k)s and traditional IRAs present more complicated tax considerations. Unlike other inherited assets, these accounts don't receive a step-up in basis, and they come with income tax obligations.

When your beneficiaries inherit a traditional retirement account, they must pay ordinary income tax on distributions. If you had $500,000 in your IRA and your daughter inherits it, she'll owe income tax on every dollar she withdraws. The tax rate depends on her income bracket, which means careful withdrawal planning becomes essential.

The SECURE Act of 2019 (and amended in 2022) changed the rules significantly for most beneficiaries. Previously, non-spouse beneficiaries could "stretch" distributions over the balance of the rest of their lifetime, which can have significant tax benefits, keeping beneficiaries in a lower tax bracket and deferring taxes over a longer period of time. Now, in most cases, all retirement benefits must be paid to your beneficiaries (and taxed for income tax purposes) within 10 years of your death. This compressed timeline can push beneficiaries into higher income tax brackets if they're not strategic about timing their withdrawals.

Spouses who inherit retirement accounts have more flexibility. They can roll the inherited account into their own IRA, allowing them to defer distributions until they reach the required minimum distribution age.

Roth IRAs offer a distinct advantage. While beneficiaries still face the 10-year distribution rule, qualified Roth IRA withdrawals are tax-free. If you've paid taxes upfront by contributing to a Roth account, your beneficiaries receive the funds without owing any income tax.

Life Insurance: Generally Tax-Free

Life insurance death benefits typically pass to beneficiaries income-tax-free, making them an excellent estate planning tool. If you have a $1 million life insurance policy, your beneficiary receives the full $1 million without paying income tax on it.

There's an important caveat regarding estate taxes. If you own the policy on your own life, the death benefit may be included in your taxable estate. For very large estates, this could trigger estate taxes even though the beneficiary won't owe income tax. Advanced planning strategies, such as irrevocable life insurance trusts, can remove life insurance from your taxable estate.

Strategic Planning Makes All the Difference

Understanding how different assets are taxed when inherited allows you to structure your estate strategically. You might choose to leave tax-efficient assets like cash or appreciated stocks to certain beneficiaries while directing retirement accounts to others who can better manage the tax consequences.

As your Personal Family Lawyer® Firm, we help you create a Life & Legacy Plan that considers not just what you're leaving behind, but how to structure your assets to minimize taxes and maximize what your loved ones receive. Tax laws change frequently, and your circumstances evolve over time, so having ongoing, strategic guidance makes all the difference between a plan that works when your loved ones need it to. That’s where we come in. 

Don't leave your beneficiaries struggling with unexpected tax bills. Click here to schedule a complimentary 15-minute discovery call and learn how we can support you:

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This article is a service of Lauderdale & Lauderdale, PC, a Personal Family Lawyer Firm. We don’t just draft documents; we ensure you make informed and empowered decisions about life and death, for yourself and the people you love. That's why we offer a Life & Legacy Planning^Ⓡ Session, during which you will get more financially organized than you’ve ever been before and make all the best choices for the people you love. You can begin by calling our office today to schedule a Life & Legacy Planning Session.

The content is sourced from Personal Family Lawyer® for use by Personal Family Lawyer firms, a source believed to be providing accurate information. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking legal advice specific to your needs, such advice services must be obtained on your own, separate from this educational material.