Dear Dollar Diva,
If I inherit some money, what is the tax rate I would have
to pay on it?
As a general rule, the tax rate on inherited property, including
money, is zilch; you don't even have to report the event on your tax return. However,
once you own the property, any income earned on it becomes taxable.
One notable exception
to this tax-free rule is the inheritance of an Individual Retirement Account (IRA).
The IRS handles each type of IRA differently; the Diva gives the highlights of
inheriting Roth and traditional IRAs below, but first, she wants to mention estate
You generally don't pay tax on inherited property, because
any tax that's due is paid out of the decedent's estate before the property is
distributed. The estate tax, also known as the "death tax," adds insult
to the injury of dying; depending on when you die and how much you leave behind,
the insult can go as high as 55 percent.
Estate tax law is
very complex, but ignoring its ramifications could cost your heirs a bundle. If
your net worth is a million bucks or better, and you'd rather leave it to your
grandchildren than Uncle Sam, ring in the New Year by setting up an appointment
with an estate tax professional.
Here are the estate tax
exemption amounts from 2002 through 2011:
The Roth IRA is funded with after-tax dollars, and
those dollars are never taxed again, no matter when they're distributed. If you
inherit a Roth IRA that is at least 5 years old, all distributions -- including
income and capital appreciation -- go to you tax-free.
bad news: The very first Roth IRA account was born in 1998, and will not
meet the five-year holding period until Jan. 1, 2003.
good news: You don't have to take the money the minute you inherit it. There's
a "five-year rule" that says you don't have to take distributions from
an inherited Roth IRA until Dec. 31 of the fifth year following the year of death.
That's more than enough time to meet the five-year holding period, and take your
For other distribution possibilities,
Publication 590, Individual Retirement Arrangements (IRAs).Inherited
The traditional, tax-deductible IRA is funded with tax-free dollars; the tax gets
paid in the future, when distributions are made to the owner or beneficiary. Expect
distributions from this type of IRA to be taxed at your marginal
tax rate, or higher.
It's usually smart to spread
out the distributions as long as you can. You'll have the advantage of tax-deferred
earnings and there's less of a chance of getting bumped up into a higher tax bracket.
You should be able to spread out the distributions anywhere from five years to
your life expectancy; IRS Publication 590 spells out the rules. It will also give
you the rules for traditional nondeductible IRA distributions.
a spouse inherits an IRA
You've probably heard about the "marriage
penalty" built into the tax code, but there's a marriage benefit when you
inherit an IRA from your spouse.
You can make the IRA your
own and keep it growing, tax-free or tax-deferred, until you're required to make
distributions. Just call the account representative at the financial institution
holding the IRA and ask what you have to do to have yourself removed as "beneficiary,"
and designated as "account owner." This is particularly nice when the
IRA is a Roth; it can grow tax-free for as long as you live.U.S.
might have to pay tax on the interest on inherited US savings bonds; it depends
on how much of the tax the decedents paid during their lifetimes and on their
final tax returns; IRS
Publication 550, Investment Income and Expenses, spells out the rules.
To learn more about inheritances, including which items
are taxed and which are not, read IRS
Publication 17, Your Federal Income Tax for Individuals.