Inheritances can be subject to complex tax rules, although they’re usually not taxed as income. If your great-aunt Kelly leaves you $500,000, you don’t have to report it on your tax return. Depending on where you live, however, you might have to hand a percentage of that money over to the state in the form of an inheritance tax.
You’re in luck if you live in Texas because the state does not have an inheritance tax, nor does the federal government. Texas repealed its inheritance tax law in 2015, but other tricky rules can apply depending on what you do with the money or property.
Taxes on Interest
An initial gift of money or property is tax-free, but if it earns any income for you, that’s taxable. If Aunt Kelly named you as the beneficiary of her life insurance policy and the insurer pays you in installments rather than lump-sum death benefits, the balance earns interest while it’s being held by the insurer. That interest is taxable as income.
The same applies if you take all the benefits at once and plunk the money – or even that $500,000 in cash she left you – into a savings, money market or investment account. The growth of that money is taxable income.
Income in Respect of a Decedent
Then there’s “income in respect of a decedent,” which can also result in taxes coming due. This is money that was due to be paid to the decedent before her death but for some reason was not. As a result, she never paid taxes on it. This might be salary, wages, unpaid vacation pay, unpaid sick pay or a bonus from her employer. It could be the result of her own investments. It could even be lottery winnings – she won but never had a chance to collect the money.
If money was earned or payable before she died but not paid until after her death, you must pay any taxes due on her behalf. Again, it’s not an inheritance tax. It’s an income tax, but the burden of paying the tax bill still falls to the beneficiary. You must declare it on your tax return as income in the year you receive it.
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Taxes on Retirement Accounts
Inherited retirement accounts are subject to an additional set of tax rules. Typically, you must pay income tax on the money when it’s withdrawn from a retirement fund. If you let the money sit in the account, you can hold onto it tax-free, but that’s rarely an option.
Unless you inherit the account from your spouse – in which case different rules apply – you’ll eventually have to begin taking required minimum distributions from it, known as RMDs. You must take annual distributions if you inherit an IRA, and those distributions are taxed as income. Several complex exceptions and other rules exist, however, so if you find yourself in this situation, you might want to consult a tax professional.
If You Inherit From Another State
If you live in Texas and spend your inheritance rather than save it, if it doesn’t represent income in respect of a decedent, and if it’s not a retirement account, you probably won’t have to pay any taxes on it at all – unless it came from one of the six states that have an inheritance tax. As of 2018, those states are Pennsylvania, New Jersey, Maryland, Kentucky, Iowa and Nebraska. Even in these jurisdictions, you might not be taxed or at least not much if you’re a close relative of the deceased.
If you end up owing an inheritance tax to one of these states because the decedent died owning the property there, you file the tax return and pay the money to that state’s department of revenue.
- Legal Consumer: Texas – No State Inheritance or Estate Tax
- Texas Comptroller of Public Accounts: Inheritance Tax
- IRS: What’s New – Estate and Gift Tax
- Texas Department of Insurance: Understanding Life Insurance
- AXA Equitable: Will My Beneficiaries Have to Pay Taxes on the Proceeds of My Live Insurance Policy?
- Investopedia: Income in Respect of a Decedent – IRD
- Charles Schwab: Inherited IRA Withdrawal Rules