Inheriting Money when Someone Dies

There are four ways you can inherit money when someone dies:

You can be named in the last will and testament of the decedent as a beneficiary of the estate
You can be named as an heir by the probate court and inherit money through intestate succession, which is the passing of the assets of a person who dies without a will
You can inherit money by being named as the beneficiary of a trust
You can inherit "by contract" as the named beneficiary of a retirement account, insurance policy, annuity, transfer-on-death bank account, etc.

In the first two examples, all monetary inheritance must go through the probate process. And like all other probate assets, money can't be distributed until all other estate expenses have been paid: court costs, attorneys' fees, administration expenses, creditors' claims, federal and any state estate taxes, etc.

In the latter two examples, inheritance bypasses the probate process and does not need to be sanctioned by a probate court.

Types of Inherited Accounts

When it comes to inheriting money, real life isn't like the movies: rarely will any money that you inherit come in the form of bundles of cash.

Generally, inherited money will come in different kinds of financial accounts. Each can have a specific set of rules and tax implications.

For example, money inherited in a brokerage account will be treated differently than money received via an IRA. Annuities are also treated differently.

Brokerage Accounts

Inherited stocks owned by the decedent and left to a beneficiary have a "basis value," their fair market value as of the date of death (or in some cases, six months after death). When the original owner dies, the value of the account "steps up" if there has been a net gain in value between the time of its purchase and the date of death, or "steps down" if there has been a loss.

Any capital gains taxes that would have been owed on a net gain is now disregarded and not owed by the beneficiary. The only liability will come if there is a net gain between the new basis value and the account's value at the time of a future sale. Likewise, net losses can't be claimed as tax write-offs, unless they occurred between the time the account was inherited and the time it is sold.

When inheriting a portfolio of investments, a beneficiary has the ability to make any changes necessary or desirable. Stocks can be bought or sold, and investment approaches can be modified.

Individual Retirement Accounts

The rules about inherited IRAs are complicated. Anyone who is the beneficiary of inherited IRA should seek competent financial advice, because the tax implications (and penalties) can be substantial.

Inherited IRAs can't be mixed with a beneficiary's IRA, and new contributions aren't allowed unless the beneficiary is a surviving spouse.

Also, non-spouse beneficiaries have to take a required minimum distribution (RMD) from the inherited account every year, regardless of age, and pay income taxes on the withdrawn amount(s). An IRA inherited by a spouse, however, can be rolled over into his or her own IRA and RMDs don't have to be taken until age 70 1/2.

Withdrawals from Roth IRAs are tax-free, and the withdrawal rules are generally the same as inherited traditional IRAs. Except for spouses, beneficiaries must make RMDs, when the account is inherited, based on their own life expectancies according to Internal Revenue Service (IRS) tables.

Likewise, 401(k) and 403(b) accounts are treated similarly as IRAs. Again, it's always advisable to check with an accountant or financial planner for exact details.

Annuities

Annuities also have their own tax implications. Many times, withdrawals must be made within a certain amount of time and part or all of the annuity may be taxable. It is important to contact the company that wrote the annuity policy to determine what options are available to a beneficiary.

Depending on the annuity, it's possible that a beneficiary will have the option to sell it to someone else averting the need to wait for monthly, quarterly or annual payments. The annuity will have to be sold for less than its face value, but this process allows a beneficiary to pull cash out of the annuity much sooner and all at once.

Money Inherited Through a Family Trust

Money inherited though a trust fund is not subject to probate, allowing it to evade estate taxes. But beneficiaries who receive trust-fund distributions must pay income taxes on any taxable assets, minus any statutory exemptions, based on their own marginal tax rates.

Because there are so many different kinds of trusts and trust documents, the taxation of trust beneficiaries can be complicated. A beneficiary receiving trust distributions should consult the fund's trustee, as well as a tax expert, to determine the most favorable tax advantages.

Money Inherited by Contract

Money inherited by a named beneficiary of a life insurance policy, a retirement plan, a pension fund, a transfer-on-death bank account, etc., also bypasses probate. The money can be claimed upon proof of identity and presentation of a death certificate.

More good news: This money is also tax-free unless the beneficiary lives in a state that imposes an inheritance tax. However, any inherited money that is then invested can change a person's tax status and influence his or her own estate's planning.