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How Much is Inheritance Tax? A Complete Guide for Inherited Assets

Jan 23, 2020 4 min read Kate Ashford

Key Takeaways

  • 401(k) and IRA accounts share many of the same inheritance tax rules.
  • Those inheriting a life insurance benefit generally owe no taxes on the payout.
  • Heirs may benefit from financial advice on how to structure distributions.


In estate planning, taxes are a key component. You may have some questions as you are working to leave a legacy : Is inheritance taxable? Is an inherited IRA taxable? How much is inheritance tax?

In all cases, your estate's total worth plays a role. Once your estate exceeds a certain value — in 2020, that's $11.58 million for individuals and $23.16 million for married couples — your assets could be subject to federal estate tax. There may also be a state estate or inheritance tax Opens in new window, though the tax rate and exemption vary.

Beyond the estate taxes that generally affect only the most wealthy, however, there are rules that apply to assets you may be passing on. Here is how your heirs may be affected.

 


Taxes for Inherited 401(k)s

Who can receive them: If you're married, your spouse will inherit your 401(k) unless they sign a waiver refusing it, no matter whom you've named beneficiary. If you're not married or your spouse signs the form, you can name anyone else as beneficiary. The beneficiary designation on a 401(k) trumps a will, so make sure you keep it up to date.

Taxes involved: For a traditional 401(k), your spouse can leave the money where it is or roll it into an inherited IRA or their own IRA. If they're under age 70 ½, they don't yet have to take required minimum distributions (RMDs).

If you leave the money to someone else, that heir will have to start taking RMDs based on either their age or your age when you died—factors in this calculation include their life expectancy, your life expectancy or withdrawing the whole thing over five years.

The heir will pay income taxes on those distributions, and there can be big differences between methods. If they're 48, for example, the IRS Life Expectancy Table Opens in new window expects them to live for 36 more years, and their IRA distributions would be spread out accordingly. If an heir chooses the five-year method, they must liquidate the account within five years after the account owner's death, which can mean a significantly greater tax hit.

Either a spouse or non-spouse can also take a lump-sum distribution and would owe taxes on the entire sum, with no 10% early withdrawal penalty.

If you're passing down a Roth 401(k), your heirs aren't subject to income taxes (assuming you’ve had a Roth account for five tax years), because you paid tax on the contributions already. If heirs don't wish to take a lump-sum distribution, they should call to inform the 401(k) account manager as soon as possible after inheriting.

What to consider: Rolling assets to an IRA might give heirs more options if you're retired or have old 401(k) accounts from a former employer. But heirs shouldn't be your only concern in doing this, so talk to a financial professional first.


Taxes for Inherited IRAs

Who can receive them: Unlike a 401(k), an IRA can be left to anyone. Just make sure you keep the beneficiary designations up to date as your life changes, as this also trumps anything in your will.

Taxes involved: The tax structure for the heir of an IRA is nearly identical to that of someone who's inherited a 401(k), with the same rollover, lump-sum and RMD options.

If you're passing on a Roth IRA, your heirs will owe no taxes on distributions as long as you've held the account for more than five tax years.


Taxes for Inherited Life Insurance

Who can receive it: You can leave your life insurance to anyone, although if you're naming a child or children, note that, in many states, life insurance can't be paid to minors under age 18. Talk to your estate planner about setting up a trust — or having your will create a trust when you die — to which you'd leave your life insurance proceeds. You can then name a trustee who could manage the funds until your children come of age. Life insurance beneficiaries trump your will, so keep these up to date.

Taxes involved: For most beneficiaries, the death benefit of a life insurance policy can be inherited tax-free and does not have to be reported as income. However, the heir may owe taxes on any interest earned if the benefit is held for a period of time before being distributed. And in a select few states, heirs may be subject to inheritance taxes that include the value of an inherited life insurance policy.

What to consider: If other assets will result in a hefty tax burden on your loved ones, life insurance can be a tool to help them offset the cost of their inheritance.


Taxes for Inherited Annuities

Who can receive it: You can leave an annuity to any beneficiary. As with the assets above, beneficiary designations trump your will.

Taxes involved: An heir can elect to receive an annuity as periodic or nonperiodic distributions, or as a lump-sum payout. If your heir chooses a lump sum, they'll pay taxes on anything over what you originally paid for the annuity. For periodic distributions, heirs pay taxes only on the part of the payment that stems from earnings. For nonperiodic distributions, which are amounts not received as an annuity, heirs pay taxes on everything until no distributions are left, at which points remaining payouts are tax-free.

Special caveats: If your annuity contract specifies guaranteed payments, your heir can receive tax-free payments up to the amount originally paid for the contract. Everything in addition to that is considered taxable income.


Taxable investments

Who can receive it: You can leave your investments to anyone, and generally this is done via your will.

Taxes involved: When someone inherits a taxable investment, the cost basis of the investment becomes the value of the investment at the time of your death. If your heirs move their inherited investments into their own account and don't sell them, they may not owe any capital gains taxes. When and if they eventually sell them, they'll be subject to normal investment tax rules. (They'll owe taxes on any gains.) In some states, heirs will also owe inheritance taxes on the value of the investments.

 

 

What you can do next

Talk to your financial professional and tax advisor about ways to minimize the tax burden on your heirs, whether it's moving assets to an account that gives them more choices or purchasing an insurance policy to help them handle a large tax bill. (This tool can help you estimate life insurance needs.) An estate planner can also help ensure you have the right documents in place — and that your beneficiary designations make sense.

 

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