Is My Children’s Inheritance Taxed?

The general answer is no. The IRS doesn’t allow much to go untaxed, but most inherited assets are the exception (in Arizona at least). It does not matter whether the beneficiary received real property, stock or cash. Nor whether he or she received the inheritance via a Will or a Trust, or from a beneficiary designation on a bank account or life insurance policy, it is not taxable income.

There are however some exceptions to this general rule which are:

• If the decedent’s estate exceeds the federal estate tax exemption amount (currently over $11,000,000), the beneficiary will pay his share of the taxes assessed for the amounts over and above the exemption.

• Any money withdrawn from a pre-tax retirement account such as an IRA or 401(k) will be taxed to the beneficiary. Since the funds in retirement accounts are generally not taxed before being placed in those accounts, the funds are instead taxed at withdrawal, whether you are the original contributor or a beneficiary of that account. (Note: This exception does not apply to after-tax accounts such as Roth IRAs and certain annuity investments.)

• Although the beneficiary is not taxed for her actual inheritance, she will be taxed on any income earned by that asset from that date forward. This would apply if she inherited her assets outright or if they are being held in a trust on her behalf. As an example, if she inherited a rental property, all rental income would be taxable, and if he eventually sold the property, any increase in value over the cost basis at the date of her inheritance would be taxed as long-term capital gains.

• Another exception to the non-taxing policy is called “Income in Respect of a Decedent.” This tax applies to any interest earned, but not paid out before the decedent’s death. A good example of this type of tax would be the IRA example above but it also includes a savings bond or a dividend paid on an investment. The beneficiary would be responsible to claim all unpaid interest on his federal and state tax returns, even if it technically accrued prior to the decedent’s death.