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Taxing Inheritances: What You Need to Know

When it comes to inheritances, tax rules can vary widely depending on several factors and understanding them can help you plan effectively. Here’s what you need to consider. 

FEDERAL ESTATE TAX

For most people, the federal estate tax won’t apply. In 2024, estates worth less than $12.92 million are exempt from federal estate tax. If the estate exceeds that threshold, the estate, not the heirs, will be responsible for any taxes before distributions are made. 

STATE TAXES

Some states still impose their own estate or inheritance taxes. Depending on the estate’s value, it can be taxed up to 12% in Connecticut and Maine and up to 16% in Massachusetts, Rhode Island, New York, and Vermont, though each state has its own exemption threshold. (In these states, the tax is levied on the estate itself before it is distributed.) Other states, like New Hampshire and Florida, do not impose an estate tax. 

INHERITED RETIREMENT ACCOUNTS

If you inherit a traditional IRA or 401(k), be aware that withdrawals will be taxed as ordinary income. However, if you inherit a Roth IRA, distributions are typically tax-free if certain requirements are met. The SECURE Act now mandates non-spousal beneficiaries to withdraw all funds from inherited IRAs within 10 years, known as the 10-year rule. 

INHERITED INVESTMENTS

If you inherit stocks, bonds, or real estate, the step-up in basis rule can save you on taxes. This means the cost basis of the asset is adjusted to its fair market value at the time of death, reducing potential capital gains taxes if you sell the asset later. 

For example, let’s say you inherit a house that your parents originally bought for $100,000, and it’s worth $400,000 at the time of their death. If you decide to sell the house for $410,000 shortly after inheriting it, you will only pay capital gains taxes on the $10,000 profit, rather than on the $310,000 difference between the purchase price and the sale price. 

LIFE INSURANCE PROCEEDS

Life insurance proceeds are not taxable for the beneficiary, offering a tax-free transfer of wealth. 

Being aware of these tax rules can help you avoid surprises and plan better when managing an inheritance. 

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