You may have heard conflicting information about taxes on inheritances. Some claim you can inherit assets tax-free, while others warn of significant tax burdens.
The truth is more nuanced. While most heirs do not pay direct taxes on what they receive, certain tax obligations can arise depending on the type of asset and how you handle it. Understanding these rules can help you avoid financial surprises.
Inheritance Tax vs. Estate Tax: What’s the Difference?
One of the biggest misconceptions about inheritances is that you will have to pay an inheritance tax. In reality, most people do not. The federal government does not impose an inheritance tax, and California does not have one either.
Only five states— Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—levy this type of tax. If the person leaving you an inheritance lived in one of these states or if the property you inherit is located there, you may owe taxes.
An estate tax, on the other hand, is a tax on the total value of a deceased person’s estate before the assets are distributed.
The federal estate tax applies only to very large estates—those exceeding $13.99 million in 2025. This means most families do not need to worry about it.
California also does not have a state estate tax, but if you inherit property in one of the 12 states with an estate tax, there could be tax implications.
Do You Have to Pay Taxes on Cash Inheritances?
Receiving an inheritance in cash is the simplest scenario from a tax perspective. You do not owe income tax on the money you inherit, no matter how large the amount.
The IRS does not consider inheritances as earned income. However, if that cash comes from an inherited retirement account or an investment that has appreciated in value, different tax rules apply.
Capital Gains Tax on Inherited Assets
One of the most important tax rules you should understand is how capital gains taxes apply to inherited assets.
When you inherit property, stocks, or other investments, you receive a step-up in basis. This means the value of the asset is adjusted to its fair market value on the date of the original owner’s death.
For example, if your parent bought a house for $200,000 but it was worth $800,000 at the time of their passing, your basis in the property becomes $800,000.
If you sell the home immediately for that amount, you owe no capital gains tax. However, if you hold onto it and later sell it for $900,000, you would owe capital gains tax only on the $100,000 increase in value after you inherited it.
This step-up in basis rule can save you a significant amount in taxes compared to if you had received the property as a gift during the owner’s lifetime. Gifting an asset before death carries the original purchase price as the basis, which could lead to much higher capital gains taxes when the asset is eventually sold.
Taxes on Inherited Retirement Accounts
If you inherit a tax-deferred retirement account, such as a traditional IRA or 401(k), you will have to pay taxes when you withdraw money from it. These accounts were funded with pre-tax dollars, meaning the original owner did not pay taxes on the contributions or investment growth.
The rules for withdrawing from an inherited retirement account depend on your relationship to the deceased. A surviving spouse can roll the account into their own IRA and continue deferring taxes until they take distributions.
If you are a non-spouse beneficiary, you typically must withdraw all funds within 10 years, unless you qualify for an exception. Each withdrawal is taxed as ordinary income, which can push you into a higher tax bracket.
Roth IRAs, on the other hand, are inherited tax-free. Because contributions were made with after-tax dollars, withdrawals—including investment gains—are not subject to income tax.
However, if you inherit a Roth IRA, you are still required to withdraw the funds within 10 years, though there are a few exceptions to this rule.
Tax Implications of Inheriting a Business or Rental Property
If you inherit a business, rental property, or other income-generating asset, the tax treatment depends on how you handle it. You receive a step-up in basis just as you would with personal property, but ongoing income from the asset is taxable.
For example, if you inherit a rental property, the value of the property at the time of inheritance becomes your new basis. If you continue renting it out, you will need to report rental income and may be responsible for property taxes, maintenance costs, and other expenses.
Inheriting a business can be even more complex, particularly if there are multiple heirs involved. You may need to address business taxes, transfer ownership issues, and determine whether to sell or continue operations. Consulting an estate planning attorney can help you navigate these challenges.
Life Insurance and Taxes
Life insurance proceeds are one of the few types of inheritances that are almost always tax-free. If you are named as a beneficiary on a life insurance policy, you receive the payout without owing federal income tax. However, if the policyholder owned a very large estate that exceeds the federal estate tax exemption, the proceeds may be included in the taxable estate.
One situation where taxes could apply is if you inherit a life insurance policy itself, rather than receiving a lump sum payout. If you take over ownership of the policy and later cash it out, you may owe taxes on the gains above what was originally paid into it.
Why You Still Need an Estate Planning Attorney
The good news is that most inheritances are not directly taxable. You do not owe income tax on cash inheritances, and estate taxes only affect the wealthiest individuals.
The step-up in basis rule provides significant tax savings on inherited property and investments, and life insurance proceeds are usually tax-free.
However, inheritances can still create complex tax issues, especially when retirement accounts, real estate, or business assets are involved.
An estate planning attorney can help you understand your tax obligations, structure your inheritance to minimize taxes, and create a plan that aligns with your long-term financial goals.
Whether you are inheriting assets or planning your own estate, professional guidance ensures you make informed decisions that protect your wealth and your family’s future.
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Attend one of our living trust seminars or watch our on-demand webinar today! Call us at 408-356-9200 or reach out through our contact form to get started. And if you already have a plan that you created years ago, we can help you update it to reflect your current situation.
