When you inherit money from somebody, the last thing you want to think about is how much tax you have to pay on it. Fortunately, most cash inheritances are tax-free. However, if you inherit retirement funds, you may have to pay taxes on them unless you qualify to roll the funds over into your own individual retirement account.
Kiplinger.com says that most cash inheritances are tax free as of May 2011. Thus, you do not have to report your cash inheritance as income or pay taxes on it. If your benefactor's estate was worth more than $3.5 million, the executor of his estate must pay taxes on the estate before distributing the cash inheritance to you. The size of your cash inheritance does not influence its cash-free status.
If you inherit a retirement account such as a 401k plan or an IRA, any withdrawals you make from that account are fully taxable, and you must report them as income on your tax return. The Internal Revenue Service treats retirement account funds the same way they would if the deceased person accessed them herself. If you inherit a Roth IRA, however, you can withdraw funds without paying taxes on them if the account is more than five years old when you begin withdrawing from it.
If you inherit a cash benefit from a deceased person's life insurance or pension plan, that benefit is fully taxable in most cases. If the person died in the September 11, 2001, attacks or other terrorist attack, you do not have to pay taxes on it, according to Kiplinger.com. Like retirement accounts, death benefits from pension or life insurance plans are treated the same way as they would be if the deceased person received the benefits himself.
Traditional IRA Exception
In most cases, if you inherit funds from a traditional IRA, you must pay the same taxes on those funds as the deceased would pay on them. However, if you do not use all the funds in the account and leave it to your heirs, they will be responsible for the taxes on the remaining balance. In addition, if you are the deceased person's spouse, you can roll his IRA funds over to your IRA rather than withdrawing and paying taxes on them.