Understanding Inheritance Taxes

When planning for your death, one critical question often gets overlooked: Will your loved ones have to pay taxes on what you leave them?

The answer depends on the type of assets you pass down, the total value of your estate, and where you live at the time of your death. Understanding how different assets are taxed can help you make informed decisions that minimize the tax burden on your beneficiaries and protect more of your wealth.

Estate Taxes: Will They Apply to Your Estate?

There are three things no one can predict: when you will die, what your assets will be worth at that time, and what the federal estate tax exemption will be. Under current law, the federal estate tax exemption is approximately $15 million per individual (or $30 million for married couples), although this amount is scheduled to change in 2026 unless Congress takes action.

If your estate falls below the exemption amount in effect at the time of your death, no federal estate tax will be due. If it exceeds the exemption, estate taxes must be paid before your beneficiaries receive their distributions. For married couples, it is especially important to review and update your estate plan after the first spouse dies to preserve the deceased spouse’s unused exemption.

In addition to federal estate tax, some states impose their own estate or inheritance taxes with much lower exemption thresholds. A comprehensive plan must take both federal and state rules into account. If you live in California, you can learn more about your options on our Estate Planning page: https://towerlawgroup.com/estate-planning/

It is also important to understand that estate tax is only one piece of the puzzle. Income tax and capital gains tax may also apply to inherited assets, depending on their type. Strategic planning requires looking at each category of asset you own.

Cash and Bank Accounts: The Simple Answer

Cash is one of the most straightforward assets to inherit. When beneficiaries receive funds from checking, savings, or money market accounts, they generally do not owe federal income tax on the amount inherited. If you leave someone $50,000 in a savings account, they receive the full $50,000.

There is one limited exception. If the account earns interest after your death but before the funds are distributed, that interest is taxable income to the beneficiary. The original principal, however, remains income tax-free. Because of this simplicity, liquid assets are often an important part of a balanced estate plan.

Investment Accounts: Understanding the Step-Up in Basis

Taxable investment accounts, such as brokerage accounts holding stocks, bonds, or mutual funds, receive a powerful tax benefit known as a “step-up in basis.”

Your “basis” in an investment is generally what you paid for it. If you purchased stock for $10,000 and it grew to $100,000, you would normally owe capital gains tax on the $90,000 increase if you sold it during your lifetime. However, when a beneficiary inherits that same stock, their basis typically steps up to the fair market value as of the date of your death. In this example, the new basis would be $100,000.

If the beneficiary sells the stock immediately for $100,000, no capital gains tax is owed. If the stock later appreciates beyond $100,000, capital gains tax would apply only to the appreciation that occurs after inheritance.

This step-up in basis can significantly reduce tax liability and is a key consideration when deciding whether to gift appreciated assets during your lifetime or hold them as part of your estate.

Retirement Accounts: A More Complex Tax Situation

Retirement accounts, such as 401(k)s and traditional IRAs, are taxed very differently from other assets. Unlike brokerage accounts, they do not receive a step-up in basis. Instead, distributions from inherited traditional retirement accounts are taxed as ordinary income.

If your child inherits a traditional IRA worth $500,000, every dollar withdrawn is subject to income tax at the beneficiary’s tax rate. Careful planning around the timing of withdrawals is essential to avoid unnecessarily high tax brackets.

The rules governing inherited retirement accounts changed significantly under the SECURE Act. Previously, many non-spouse beneficiaries could stretch required distributions over their lifetime. Now, in most cases, beneficiaries must fully distribute inherited retirement accounts within ten years. This compressed timeline can increase the overall tax burden if withdrawals are not strategically planned.

Spouses who inherit retirement accounts generally have more flexibility. They may roll the account into their own IRA and defer distributions until they reach the applicable required minimum distribution age.

Roth IRAs are treated more favorably from an income tax perspective. Although beneficiaries are still subject to the ten-year distribution rule in most cases, qualified withdrawals from a Roth IRA are income tax-free because taxes were paid upfront on contributions.

Life Insurance: Income Tax-Free in Most Cases

Life insurance death benefits are generally received income tax-free by beneficiaries. If you have a $1 million life insurance policy, your beneficiary typically receives the full amount without paying income tax.

However, if you own the policy on your own life, the death benefit may be included in your taxable estate for estate tax purposes. For individuals with large estates, this could increase estate tax exposure. Advanced planning techniques, such as using certain types of trusts, can remove life insurance proceeds from your taxable estate. To explore these strategies, visit our Trusts page: https://towerlawgroup.com/trusts/

Frequently Asked Questions About Inheritance Taxes

Q: Do beneficiaries pay income tax on inherited cash?

A: No. Cash from bank accounts is not subject to federal income tax, except for any interest earned after death and before distribution.

Q: Do inherited stocks trigger capital gains tax?

A: Beneficiaries receive a step-up in basis to the value at the date of death. Capital gains tax applies only to appreciation that occurs after inheritance.

Q: Are inherited IRAs taxable?

A: Yes. Traditional IRA distributions are taxed as ordinary income when withdrawn.

Q: Is life insurance taxable?

A: Life insurance proceeds are generally income tax-free, though they may be included in your estate for estate tax purposes if you own the policy.

Strategic Planning Protects Your Legacy

Estate planning is not just about deciding who receives your assets. It is about structuring those assets in a way that minimizes taxes and maximizes what your loved ones ultimately keep.

Through a Legacy Planning Session, we help you evaluate your assets, understand potential tax exposure, and create a plan tailored to your family’s goals. Because tax laws and personal circumstances evolve over time, your estate plan should be reviewed regularly to ensure it continues to serve your needs.

If you are ready to protect your family and create clarity around your estate, schedule your Legacy Planning Session today by visiting:https://towerlawgroup.com/estate-planning/

A thoughtful plan today can prevent confusion, conflict, and unnecessary taxes tomorrow, ensuring your loved ones receive the full benefit of your legacy.

📞 Book a free 15-minute discovery call to explore how a Legacy Planning Session protects your whole family.