By Financial Advisor Peter Egolf | Updated January 9, 2024
The best options for claiming and investing inherited assets depend on four primary factors:
If you are expecting or recently received an inheritance as the beneficiary of an investment account, the first step is understanding the account type(s).
Commonly inherited accounts include
To understand the implications of inheriting a brokerage or trust account, you must understand the concept of cost basis. Cost basis refers to the original price paid for an asset or investment, and it is used to calculate the amount of tax (applicable to the capital gain or loss) when selling an asset.
When an individual passes away, the cost basis on their non-retirement assets is “stepped-up” to the current fair market value, including real estate, collectibles, etc. This step-up also pertains to the decedent’s taxable investments, including securities (ETFs, mutual funds, stocks, and bonds) held within a brokerage account and some trust brokerage accounts (e.g., revocable or living trusts).1
For example, an individual purchases $100K of stock, and years later, the stock is now worth $1M on the date of their death. The original cost basis of $100K would be increased (or stepped up) to $1M, eliminating $900K in otherwise taxable gains.
Thus, beneficiaries receiving inherited assets in taxable accounts obtain a new cost basis valued on the decedent's date of death ($1M in the above example) rather than the price the decedent initially paid for the asset ($100K in the above example). Note that jointly held assets receive a 50% step-up in cost basis when only one account holder passes (e.g., Joint Brokerage account).
Commonly, the decedent held their assets for an extended period. Thus, the new stepped-up cost basis may be significantly higher than the older cost basis, as illustrated in the above example ($1M vs. $100K). Beneficiaries can benefit when they sell these inherited positions, as an increased cost basis would help minimize the capital gains taxes required to be paid. In the example above, the step-up in cost basis negates $900K of taxable gains.
A beneficiary would claim these taxable assets by opening a new taxable account in their name per the designation of a will or as the designated account beneficiary (e.g., brokerage transfer on death or trust beneficiary). This account is where the inherited positions will be transferred with the new stepped-up cost basis.
I inherited a retirement account. What should I do?
A decedent’s retirement assets follow a different path to their inheritors, including essential rules for beneficiaries. Retirement assets are taxed-advantaged for the original account holder (IRAs, 401K, 403B, 457B, etc.). After the original account holder dies, the government wants to collect tax dollars from tax-deferred accounts (Traditional) and limit the duration of tax-free growth (Roth) for the beneficiaries. Generally, the federal government forces beneficiaries to withdraw from these accounts through mandatory distributions.
In 2020, the SECURE Act changed the rules for many beneficiaries who inherit retirement accounts. The IRS clarified these rules in 2022 and introduced SECURE Act 2.0, which amended the rules yet again. A key change was the increase in age for the Required Beginning Date, which is the point at which retirees must begin taking Required Minimum Distributions (RMDs).2 This update impacts beneficiaries.
These beneficiaries include:
If the descendent held a Roth account or died before their Required Beginning Date, the beneficiary has two options:4
If the decedent died on or after their Required Beginning Date, the beneficiary must take RMDs based on the beneficiary’s age starting the year after death.6
In both cases, spouses have the greatest flexibility in that they can avoid these rules altogether by claiming the assets as their own.7,8 The spouse would not open an Inherited IRA but instead place the assets in their own IRA as if they were originally contributing the assets. Thus, they would follow their own RMD timing if required.
If you are not a spouse or one of the eligible designated beneficiaries above, you are a Non-Eligible Designated Beneficiary and fall under the new 10-Year Rule. This includes most non-spouse beneficiaries.
Beneficiaries typically transfer the assets into an Inherited IRA held in their name, from which distributions can be made. While the beneficiary can determine the optimal strategy to receive distributions – considering their income needs and specific tax implications – they must fulfill the IRS requirements yearly. The IRS tax penalties for missing required minimum distributions is now 25%.10
Is my inheritance taxed?
As a beneficiary, you may be required to pay taxes on your inherited assets in the future. It depends on the types of accounts you receive and what you do with those accounts.
As an advisor, I have navigated the complexity of inheritances myself and with my clients. While it is an overwhelming set of rules, there is an opportunity to improve and simplify your financial picture if done properly.
If you would like to help with investing your inheritance, please get in touch with me at firstname.lastname@example.org.
1 An exception to this rule applies to Irrevocable Trusts, which are considered a separate tax entity, and commonly do not receive a step-up in basis.
2 Now, April 1 of the year following the calendar year in which the decedent reached age 72 (if born before 1951), 73 (if born between 1951 and 1959), and 75 (if born in or after 1960).
3 Once the minor child of the decedent reaches the age of majority, the 10-Year Rule applies.
4 It’s important to note that Plan/IRA custodians are not required to offer both options. They can require either.
5 Spouses may delay RMDs until the year the decedent would have turned 72 (if born before 1951), 73 (if born between 1951 and 1959), and 75 (if born in or after 1960).
6 The beneficiary(ies) must also complete the decedent’s RMD in the year of death if it was not done so.
7 Depending on your circumstances as a spouse, there can be advantages/disadvantages to claiming assets as your own or in an inherited account.
8 SECURE Act 2.0 provides that a surviving spouse may elect to be treated as the deceased employee for purposes of the RMD rules for employer-sponsored plans, effective beginning in 2024.
9 The beneficiary(ies) must also complete the decedent’s RMD in the year of death if it was not already taken.
10 It was previously 50% before the SECURE Act 2.0 IRS Required Minimum Distribution (RMD) FAQs
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