Reporting Inheritance Income and Dealing With Taxation


When it comes to managing income obtained from an inheritance, the adage about the inevitability of death and taxes becomes evident to a certain extent. Financial planners and law firms that specialize in probate law often recommend setting up certain structures such as trusts to protect heirs from estate taxation, but this is not the case for everyone.

First of all, heirs must know that the Internal Revenue Service will not assess taxes based on inherited income up to a certain level. As for state revenue collection agencies, the following jurisdictions had some level of taxation on inherited cash as of 2018:

* Iowa
* Kentucky
* Maryland
* Nebraska
* New Jersey

Let’s say a woman in Florida files the will of her late husband in probate court; once the estate administrator closes the decedent’s bank accounts and consolidates them into a single check worth $74,000, the widow will not have to worry about reporting that inheritance as income.

A widow residing in the states listed above will have to check with the local revenue collection agencies as to how inheritance income should be reported. In Iowa, for example, inheritance cash can be taxed between 5 and 15 percent according to the relation between the decedent and the heirs, but only on amounts greater than $25,000.

In essence, inheritance income is not taxed by the IRS; nonetheless, it is important to note that this is not the same as estate taxation, which as of 2017 is assessed when an individual leaves $5,490,000 to heirs upon passing away. The heirs are not necessarily on the hook to pay taxes on the estate, but the administrator will be called upon to file the proper return and pay taxes as determined by the IRS.

With the above in mind, there are some exceptions when the inheritance itself generates income or is deposited in retirement plan accounts. Let’s say two sisters in California inherit a home that their mother was renting to a family for $2,000 per month. While the property can pass to the heirs without taxation, the rent payments receive will be treated as taxable income and must be reported. If the probate court determines that ownership of the home should be distributed 50/50, each sister should report the $600 received each month until the lease contract expires or is terminated.

Things are different when the inherited cash is in a 401(k) plan or in an individual retirement account. These investment vehicles allow account holders to skip paying taxes when they make contributions; if this is the case, the heirs will have to report income when they take money out of the inherited plans. Whether this income will be taxed or not depends on the personal tax bracket, deductions and filing status of the heirs.

When heirs receive Roth IRA or 401(k) accounts, no income tax will be due since the account holder already paid taxes at the time they made contributions. Reporting income derived from inherited Roth retirement is a situation that should be analyzed by a tax attorney or by a CPA.