At the time of a family loss, the last thing anyone wants to be thinking about is taxes. Unfortunately, the deceased's estate and heirs are likely subject to special income taxes, depending on the nature of the situation. Some investment portfolios are considered tax-free for their beneficiary, though they might be subject to capital gains tax if the heir decides to cash them out. Understanding the tax obligations arising from an inherited portfolio is important both for those planning to pass on, and those receiving, an investment portfolio.
If an investment portfolio is a part of an estate with more than $3.5 million in assets, it may be subject to the estate tax. The estate tax is a kind of income tax levied by federal and state on large inheritances. The heirs receiving an investment subject to the estate tax do not need to pay the tax, as it will be submitted to the IRS by the estate's executor before the assets are distributed to heirs. Heirs may have to pay income tax on any earnings the estate realizes after the decedent's death but before they receive the inheritance.
While a heir usually does not owe income tax on inheritances, he or she may have to pay income tax on any earnings the estate realizes after the decedent's death but before the heir receives the inheritance. In addition, the estates of decedents who passed in 2010 do not owe an estate tax, as an oddity of federal tax law essentially exempted estates inherited in that year. The estate tax situation for trusts is a little different than normal estates, and can in some cases result in a tax savings.
Heirs generally do not owe income taxes on an inherited portfolio -- after the estate tax, if applicable, has been paid. There are some exceptions. Eight states -- Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee impose an "inheritance tax," which is applied to the individual heir who receives the portfolio. There is no inheritance tax at the federal level, though the heir may owe a capital gains tax on an inherited portfolio if he chooses to sell the assets in it.
Investment portfolios inherited as a part of a 401(k) retirement plan or individual retirement account are often subject to income tax. This is because distributions from an 401(k) or IRA are considered taxable income to the beneficiary, while a portfolio received directly from the estate is not. Exceptions to this rule are Roth IRAs and 401(k)s, which are not taxable if they were open for at least five years before the decedent's death.
- Internal Revenue Service; Publication 950--Estate Tax; 2009
- "Kiplinger"; Inheritance and Income Tax; Kevin McCormally; 2011
- "USA Today"; Inheriting 401(k) Gets More Tax Friendly for People Other than Spouses; Sandra Block; 2006
- AXA Equitable; Choosing a Beneficiary for Your IRA or 401(k); 2007
- Internal Revenue Service; Publication 17--Retirement Plans, Pensions, and Annuities; 2010
- Internal Revenue Service; Publication 17-- Individual Retirement Arrangements (IRAs); 2010
Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.