Inheritance tax: What it is, how it works and ways to plan

Inheritance tax: What it is, how it works and ways to plan

Though you may not have immediate tax implications, planning for the long term can help.

Everything about the baby boom generation is big. From its sheer size in numbers to its huge impact on culture and business, the baby boom generation has fundamentally reshaped America. And the impact will continue long into the future, due in part to the unprecedented $78 trillion in estimated wealth baby boomers will transfer to their children, heirs and philanthropic causes.

Perhaps unsurprisingly, baby boomers are not following traditional norms in either their approach to retirement or in designating what will happen to their assets after they are gone. “When people used to retire, they retired at a certain age and got their pension and were fine,” says Cindy M. Campbell, a senior wealth strategist at Regions Bank. “But now people are working so much longer, and it’s not one consistent time where they’re all going to turn 65 and retire. That makes it hard to predict how younger generations will inherit that wealth.”

It’s not just that baby boomers are working and living longer than previous generations. Many in the generation want to see the wealth they plan to pass on making an impact on their loved ones and causes they care about while they are still alive. “I think you’ll see a lot more people considering a lifetime transfer of wealth to some extent in addition to a more traditional inheritance,” says Campbell.

Tax consequences of an inheritance

Regardless of how and when someone wants to transfer their assets, it’s important for their heirs to be educated about the potential tax implications of an inheritance. Campbell routinely fields one common question from those who inherit assets: Are there immediate income tax implications?

“There are no income tax consequences if someone passes away and transfers wealth to you,” says Campbell. While there are no immediate income tax implications, heirs may be subject to an estate tax depending on the size of the inheritance and the state in which they live. In 2024, estates with a value below $13.61 million per person (and double that amount for a married couple) are exempt from the estate tax. That exemption, however, is scheduled in 2026 to decrease to about $7 million per person and $14 million for a married couple.

While there are typically no immediate income tax concerns when assets are transferred to children or a spouse, there are potential consequences after the transfer happens if the heir decides to sell the asset.

For example, when a child or spouse inherits an investment account, they receive what is known as a step-up in basis. Here’s what that might look like:

  • 10 years ago: Let’s say a husband purchased a stock for $100 a decade ago and the stock’s value doubles by the time of his death and his wife inherits it.
  • Today: The wife who inherits the stock receives a step-up in basis to $200. This simply means whenever the wife opts to sell the stock, the capital gains assessed on the sale will be based on the increase in value from the time the husband purchased it.
  • Later: Say the wife sells the stock when it is worth $250, the capital gains taxes will apply to the $50 increase since she inherited it rather than the $150 increase from when the husband originally purchased the stock.

The same step-up in basis also applies to real estate and business inheritances.

Tax implications of inherited IRAs and 401(k)s

There can also be tax implications if an inheritor opts to take distributions from an inherited individual retirement account (IRA) or 401(k). Remember, one of the big incentives for investing in IRAs and 401(k)s is that taxes are deferred until money is withdrawn. But deferred doesn’t mean eliminated, and inheritors of IRAs and 401(k)s will still have to pay taxes as they withdraw funds. “The income taxes that Mom deferred on her IRA during her lifetime still have to be paid when Mom passes away,” says Campbell. “There’s no step-up in basis with these retirement accounts and the IRS still expects to be paid on the deferred taxes when the child takes distributions from the IRA.”

Those who inherit IRAs also need to account for changes made by the SECURE Act, which became law in 2019. In the past, inheritors of an IRA could take distributions over the course of their remaining lifetime. The SECURE Act, however, requires IRA distributions be completed within 10 years of inheriting the asset for certain beneficiaries. “It used to be that an adult child could take out distributions over their lifetime and spread out their income tax liability,” says Campbell. “Now they have to pay that income tax a lot quicker.”

Wealth management principles remain the same

Understanding there are varying tax nuances depending on the type of assets someone inherits underlines the importance of planning. For example, estate planning designed to limit tax consequences should keep in mind the differing tax treatment between investment account and retirement assets. “Maybe someone will decide to give their IRA to charity because the charity doesn’t have to pay taxes on distributions and use another asset to provide for their children,” says Campbell.

People receiving an inheritance also need to do wealth planning which includes, but is not limited to, tax planning. Those who inherit a traditional IRA can potentially eliminate the taxes they pay on distributions by converting it to a Roth IRA if, for example, they expect to be in a higher income tax bracket when they withdraw money from the Roth IRA. In that case, it may make financial sense to pay the taxes owed on the traditional IRA distributions.

The fundamental principles that guide effective wealth planning apply when someone inherits assets. This means integrating inherited wealth into an existing financial plan and making sure it supports your short- and long-term goals and appetite for risk.

Which means critically assessing the assets and making changes to suit your unique needs. “Let’s say it’s a taxable account you inherit. Does it still make sense to have the account invested the way it is currently given your age and goals?” says Campbell. “Do you want the vacation residence Mom and Dad left for you? How does the inheritance fit in with your overall financial picture, your taxes and your planning goals for your family? Ultimately, you want to use an inheritance to help you and your family in the best way possible.”

Talk to your Regions Wealth Advisor about:

  1. How to preserve and grow new wealth.
  2. Ways you can define and work toward your long- and short-term financial goals.

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This information is general education or marketing in nature and is not intended to be accounting, legal, tax, investment or financial advice. Although Regions believes this information to be accurate as of the date written, it cannot ensure that it will remain up to date. Statements of individuals are their own—not Regions’. Consult an appropriate professional concerning your specific situation and for current tax rules. This information should not be construed as a recommendation or suggestion as to the advisability of acquiring, holding or disposing of a particular investment, nor should it be construed as a suggestion or indication that the particular investment or investment course of action described herein is appropriate for any specific investor. In providing this communication, Regions is not undertaking to provide impartial investment advice or to give advice in a fiduciary capacity.