How to Invest an Inheritance | 2023 Inheritance Rules

By Financial Advisor Peter Egolf | Updated February 10, 2023

How to Invest an Inheritance?

The best options for claiming and investing inherited assets depend on four primary factors:

1. The original account type(s).
2. The age and date of death of the deceased account holder.
3. Your relationship to the deceased account holder.
4. Taxation.

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

• Taxable Accounts (Brokerages and Trusts)
• Individual Retirement Accounts (IRAs)
• Employer-sponsored retirement accounts (401ks, 403b, 457b, etc.)

Inheriting Brokerages and Trusts

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 (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.

Inheriting Retirement Accounts - IRA, 401k, 457b, etc.

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). This update potentially impacts beneficiaries.

Eligible Designated Beneficiaries

These beneficiaries include:

• Spouses
• Minor children of the deceased owner who have not reached the age of maturity (21)³
• Disabled Persons
• Chronically Ill
• Beneficiaries who are not more than 10 years younger than the deceased (e.g., the descendent is 45 years old, and the beneficiary is 40 years old.

If the descendent held a Roth account or died before their Required Beginning Date, the beneficiary has two options:⁴

• Begin taking Required Minimum Distributions (RMDs) based on the beneficiary's age starting the year after the year of death⁵, or
• Follow the 10-Year Rule by distributing the balance of the inherited account by December 31st of the tenth year after the year of death.

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.

Everyone Else (Non-Eligible Designated Beneficiaries)

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.

• If the decedent had a Roth account or died before their Required Beginning Date, the beneficiary must distribute the balance of the inherited account by December 31st of the tenth year after the year of death.
• If the decedent died on or after their Required Beginning Date, the beneficiary must distribute the balance of the inherited account by December 31st of the tenth year after the year of death AND must take Required Minimum Distributions (RMDs) based on their own life expectancy during years 1 through 9.⁹

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

Inheritance Taxes

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.

• Taxable Accounts (Brokerages/Trusts) – Each year, the income you receive from your investments (e.g., dividends and interest) is taxable to you. Additionally, when you sell the assets (e.g., an investment position), you will realize either capital gains or losses based on the difference between the cost basis and the sale price.
• Pre-Tax Retirement Accounts (Inherited Traditional IRA) – Distributions, whether lump-sum, 10 Year Rule, or RMDs, are taxed as ordinary income at the federal and often state level.
• After-Tax Retirement Accounts (Inherited Roth IRA) – There are no taxes owed unless the original account holder held the account for less than five years or those assets were converted within the last five years. Because the decedent paid the taxes upfront at the time of contribution/conversion, you do not pay taxes on distributions as the beneficiary as long as you meet these time requirements.

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 peter@onedayinjuly.com.

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