Reporting Inherited Investment Funds: A Step-By-Step Guide

Inheriting money or assets can be a life-changing experience, but it's important to understand the tax implications and reporting requirements to avoid penalties and legal issues. While beneficiaries generally don't need to report inheritances on their tax returns, there are situations where reporting is necessary, such as when the inheritance includes income-generating assets or retirement accounts. Understanding the tax obligations and reporting requirements for inherited investment funds can be complex, but it is crucial to ensure compliance with tax laws. This paragraph aims to provide an introduction to the topic of reporting inherited investment funds, highlighting the importance of navigating the tax implications and seeking guidance when needed.

Understanding the tax implications of inherited wealth

Income Tax

According to federal tax laws in the United States, most inherited assets are not considered taxable income. This means that when you inherit assets in the form of cash, stocks, real estate, or other valuable properties, you don't have to pay federal income taxes on them at the time of transfer. However, the income generated from these inherited assets, such as dividends from stocks, rent from rental properties, or interest from cash accounts, is considered taxable income under federal law.

Additionally, certain assets and untaxed income sources are classified as "income in respect of a decedent" (IRD). These include uncollected salaries, bonuses, deferred compensation, pension income, and the deductible portion of retirement accounts like 401(k)s and IRAs. IRD assets are taxed as ordinary income when received or distributed by the beneficiary. In some cases, the beneficiary may be eligible for an income tax deduction if estate taxes were paid on these assets by the decedent's estate.

Estate Tax

Estate taxes are levied on the entire value of the decedent's estate before any assets are distributed to heirs. While there is no federal inheritance tax in the United States, there is a federal estate tax for estates valued over a certain threshold. In 2024, this threshold is $13.61 million, and it is expected to revert to $5 million (adjusted for inflation) after 2025 unless Congress makes the current exemption permanent. The federal estate tax rate ranges from 18% to 40%, and it is assessed only on the portion of the estate that exceeds the exemption amount.

Some states also impose their own estate taxes, which can further reduce the value of the estate before inheritance distribution. These state estate taxes are typically progressive, meaning the tax rate increases as the value of the estate grows.

Inheritance Tax

Inheritance tax, which is levied by some states, is paid by the beneficiary of the inheritance rather than the estate. As of 2024, only six states collect inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. However, Iowa will phase out its inheritance tax by 2025. The amount of inheritance tax owed depends on the value of the inheritance, the relationship between the decedent and the beneficiary, and the state in which the decedent lived or owned property. Close relatives often benefit from lower tax rates or exemptions.

Capital Gains Tax

If the assets you inherit appreciate in value after you receive them, you may be subject to capital gains tax if you decide to sell them. The capital gains tax rate is based on the profit made from the sale. Additionally, certain types of inherited assets, such as retirement accounts like IRAs or 401(k)s, may create taxable income when you take distributions from them.

In summary, while inheriting wealth is generally not considered taxable income at the federal level in the United States, there are tax implications related to income tax, estate tax, inheritance tax, and capital gains tax that beneficiaries should be aware of. Understanding these tax implications can help individuals and families make informed decisions about inheritance planning and wealth preservation.

Reporting inheritance income to the IRS

When a loved one passes away, the last thing you want to think about is taxes. However, if you've inherited investment funds, you may need to report them to the IRS. Here's a guide to help you navigate the process:

Determining Taxability

Firstly, it's important to determine if the inheritance is taxable. Money or property received from an inheritance is typically not reported to the IRS. However, a large inheritance may raise red flags and trigger an audit. If the IRS suspects discrepancies between your financial documents and your tax claims, they may initiate an audit. In such cases, you will receive a letter and an Information Document Request from the IRS, seeking additional information.

Proving the Source of Funds

If the IRS requests proof of the source of your inherited funds, you should gather relevant documents. These may include the will, death certificate, transfer of ownership forms, and letters from the estate executor or probate court. Contact your bank or financial institution to obtain copies of deposited inheritance checks or authorization of direct deposits. If you received the inheritance in cash, request a bank statement reflecting the deposit.

Reporting Inheritance Income

If the inheritance includes income such as interest, dividends, or rents, it is generally taxable on the income tax return of the beneficiary. This income should be reported on your tax return, just as it would have been reported by the deceased if they were still alive. You can use Form 1040, Schedule D, and Form 8949 to report capital gains and losses from the sale of inherited property. The basis of the inherited property is typically the fair market value (FMV) on the date of the decedent's death. If the executor of the estate chooses to use an alternate valuation, you may use the FMV on that date instead.

State Inheritance Taxes

In addition to federal taxes, inheritance tax may also be applicable at the state level. Currently, 11 states have an estate tax, and five states have an inheritance tax. Consult a tax professional or refer to your state's tax laws for more specific information.

Seeking Professional Help

Navigating taxes, especially in the context of inheritance, can be complex. Consider seeking assistance from a tax professional or a tax preparation service. They can help you maximize your tax savings and ensure you're taking advantage of any relevant deductions or exclusions.

Estate tax exemptions

The Tax Cuts and Jobs Act (TCJA) of 2017 roughly doubled the amount of exemptions, allowing individuals to shield $12.92 million and couples up to $25.84 million from estate tax liability in 2023. These exemptions are temporary and are set to sunset on January 1, 2026, reverting to 2017 levels adjusted for inflation. This means the exemptions are expected to be around $7 million for individuals and $14 million for married couples after 2025. Estates valued above the exemption levels may be taxed at a rate as high as 40%.

It is important to note that the federal estate tax exemption is adjusted annually for inflation, and the new exemption amount is announced each year. Additionally, some states impose their own estate and inheritance taxes, which may have lower exemption amounts. For example, the exemption amount in Massachusetts and Oregon is only $1 million. Therefore, it is essential to stay informed about the current exemption levels and plan accordingly, especially for individuals with sizable assets.

To prepare for potential changes in estate tax exemptions, individuals can consider strategies such as spousal lifetime access trusts (SLATs), family limited partnerships (FLPs), or family limited liability companies (FLLCs). These strategies can help maximize exemptions and protect assets from tax liability. Consulting with a wealth advisor or estate planning specialist can provide personalized guidance based on an individual's specific situation.

State inheritance taxes

The rates and exemptions of state inheritance taxes vary across the six states that impose them. For example, in New Jersey, surviving spouses, parents, children, and grandchildren are exempt from the tax. However, a brother, sister, niece, or nephew can pay a tax rate of up to 16% on the inheritance. In Pennsylvania, a surviving spouse is exempt, an adult direct decedent pays a 4.5% tax, a sibling pays a 12% tax, and other heirs pay a 15% tax.

In 2021, state and local governments collected a combined $6.7 billion in revenue from estate and inheritance taxes. This amount is expected to decrease as, historically, states have been moving away from estate or inheritance taxes or have raised their exemption levels.

Consult a tax professional

Dealing with the death of a loved one is a difficult and emotional time, and the last thing anyone wants to think about is taxes. However, if you've inherited investment funds from a deceased loved one, understanding the IRS reporting requirements is crucial to avoid potential penalties and legal issues.

Consulting with a tax professional is highly recommended to help you navigate the complex tax laws and regulations surrounding inherited investment funds. They can provide tailored advice and guidance to ensure you are in compliance with tax laws and help you understand your specific tax obligations and any potential tax benefits.

For example, if you inherit a stock or mutual fund, there may be a step-up in the cost basis, which means the cost basis of the investment is adjusted to its value at the time of the original owner's death. This can have significant tax implications, and a tax professional can help you understand how to report this on your tax return.

Additionally, if you inherit a retirement account, such as a traditional IRA or 401(k), there are specific rules and timelines that you must follow, which can be complicated and subject to change. A tax professional can help you navigate these rules and determine the best course of action for your specific situation.

Furthermore, if the inheritance includes any income generated by the investments, such as dividends from stocks, that income must be reported on your tax return. A tax professional can help you identify and report all the necessary information to ensure you are compliant with tax laws.

By consulting with a tax professional, you can ensure that you are meeting all your tax obligations and taking advantage of any potential tax benefits. They can provide clarity and peace of mind during an emotional and challenging time, helping you make informed decisions about your newfound wealth.

Frequently asked questions