Smart Tax Moves for Managing an Inheritance

Receiving an inheritance can stir up a complicated mix of emotions. Amid the gratitude and grief, there’s often a layer of uncertainty, especially when it comes to handling the financial side. Whether you've inherited cash, property, investments, or retirement accounts, it’s important to know that not all assets are treated the same when it comes to taxes.

If you’ve recently received an inheritance or think you may receive one soon, knowing the rules can help you make more informed decisions and potentially preserve more of your inheritance over the long term. Here are five tax considerations to keep in mind.

1. Be Strategic About Your Annuity Death Benefits

If you inherit an annuity, you may be given a few options when receiving the death benefit. The choice you make can have a significant impact on how much of that money stays in your pocket after taxes.

Your options typically include:

Taking a Lump-Sum Payment

Just as it sounds, you may receive the entire death benefit in the form of a one-time payment. While this offers immediate access to the full amount, the death benefit is generally taxed as ordinary income. Receiving a lump sum of taxable income will likely push you into a higher tax bracket, increasing your tax burden (potentially significantly). 

Emptying the Account Within Five Years

If you aren’t the spouse of the deceased and opt not to take a lump-sum payment, you may be subject to the five-year rule. You must deplete the account within five years of the day the original policyholder died. Spreading withdrawals across several years can help mitigate the tax impact as compared to taking a lump-sum payment. However, depending on the size of the death benefit and your other taxable income, it can still create a significant tax burden each year.

Annuitizing the Death Benefit

You may have the option to convert the balance of the death benefit into a steady stream of income payments over your lifetime or a set period of time. Doing so can help smooth out that tax liability across multiple years. Just keep in mind, you won’t be able to access the funds as freely as you would if you opted for a lump-sum payment.

Using a Non-Qualified Stretch Option

This allows you to take required minimum distributions (RMDs) based on your life expectancy. The majority of the funds would stay invested and compound tax-deferred.

For many inheritors, the non-qualified stretch can be a tax-efficient alternative to a lump sum or rapid withdrawal. It lets the account continue growing while spreading out taxable income gradually. However, annuity contracts differ widely, and some older policies may limit your options. Work with an advisor to review the fine print and confirm what’s allowed under your specific contract.

2. Consider a 1035 Exchange

A 1035 exchange (or “like-kind exchange”) allows you to transfer the cash value of one life insurance or annuity policy into another similar policy without triggering immediate taxation. Essentially, you’re rolling the value into a new product that could be better aligned with your goals or time horizon for retirement.

For example, if you’re set to receive a $500,000 taxable payout from an inherited annuity, you might use a 1035 exchange to transfer the value into an investment-only annuity. You could then spread your withdrawals over several years. Doing so would allow you to better manage the income taxes owed and, ideally, avoid a sudden spike in taxable income.

3. Take Advantage of Step-Up in Cost Basis

One of the most valuable tax benefits of inheriting stocks, real estate, and other non-retirement assets is the step-up in cost basis.

If you’re unfamiliar, the cost basis is the original price paid for an investment or asset. When a person dies, the cost basis of an inherited asset resets to the fair market value on the date of the original owner’s death.

Here’s why that can create a significant tax advantage for inheritors:

Let’s say your dad bought shares of a company for $20,000 back in 1990. On the day of his death, the shares were worth $100,000. Now, you inherit the shares and sell them immediately, before they have time to continue rising in value. The cost basis and the price you sell your shares for will be virtually the same (though, of course, there could be some small fluctuation). As a result, your capital gains tax liability will be little to nothing. If you sold the shares right away and the step-up in cost basis didn’t apply, you could owe taxes on the gains that were earned while your parents were alive (approximately $80,000). 

Even if you choose to inherit and hold the assets for longer, the higher step-up in cost basis can still provide capital gains tax relief when the time does come to sell.

4. Understand Your Beneficiary Status (When Applicable)

Inherited IRAs and 401(k)s follow their own set of rules, which depend heavily on who you are in relation to the deceased.

Spouses are awarded the most flexibility. Often, a spouse will roll the inherited IRA into their own retirement account or open an Inherited IRA and roll the funds into there. If rolling into their own account, the funds will be subject to the surviving spouse’s RMD timeline. If the funds are rolled into an Inherited IRA, RMDs will either be required to begin by December 31 of the year the original account owner died, or in the year they would have turned 73. 

Non-spouse beneficiaries (such as adult children, siblings, or friends) generally must empty the account within 10 years of the original owner’s death, which has the potential to create some tax planning complexity since withdrawals are subject to tax.

Even if you’re subject to the 10-year withdrawal rule, there are opportunities to be strategic with how and when you distribute funds from the account. For instance, if you take time off work or experience a lower-income year, it could be an ideal time to draw larger amounts from the inherited account while staying in a lower tax bracket.

You may also be able to offset some of that taxable income by increasing your own pre-tax retirement contributions to a 401(k) or traditional IRA, if you aren’t already maxing out the annual contribution limits. 

5. Gather Your Team of Professionals

An inheritance of any size or complexity can bring with it some confusion. Between investment decisions, beneficiary rules, and tax considerations, it can quickly feel overwhelming and frustrating. Worse yet, neglecting to act or making hasty decisions can lead to costly mistakes or long-term tax consequences.

If you haven’t already, gather up your own team of professionals who are well-equipped to coordinate and manage the complexities of your inheritance. Together, your financial advisor, estate attorney, and tax professional can help you:

• Understand the tax treatment of each asset

• Evaluate the pros and cons of your withdrawal or reinvestment options

• Align inherited assets with your broader financial goals or concerns

• Create a tax-efficient plan to preserve and grow your inheritance

When managed thoughtfully, an inheritance can accelerate your retirement goals, increase your financial security, and even create opportunities for your own legacy planning. 

If you’d like to speak with a financial professional about a recent inheritance or get proactive about what could be coming down the road, we encourage you to reach out and schedule time to talk with our team. 

Robert "Fenn" Giles III, CFP®, CAIA is a Managing Partner of Wealth Advisors of Tampa Bay and serves on the firm’s Management and Investment Committees. WATB is an independent Registered Investment Advisor (RIA) located in Tampa, Florida. Learn more about them at wealthadvtb.com.  

This material has been edited with the assistance of artificial intelligence tools. The information presented is based on sources believed to be reliable and accurate at the time of publication. This material is for educational purposes only and does not necessarily reflect the views of the author, presenter, or affiliated organizations. It should not be construed as investment, tax, legal, or other professional advice. Always consult a qualified professional regarding your specific situation before making any decisions.