Taxes on Inherited Accounts

Introduction

Inheriting assets can be bittersweet. While it often follows the loss of a loved one, it can also provide financial stability and opportunities. Along with the emotional and financial aspects come tax implications, especially for inherited accounts. Understanding taxes on inherited IRAs, 401(k)s, taxable investment accounts, and other assets is essential. Mistakes can lead to unnecessary tax bills or penalties, so staying informed is critical for effective estate planning and financial management.

Understanding Taxes on Inherited Accounts

When you inherit an account, it is important to understand the different types of taxes that may apply: income tax, estate tax, and inheritance tax. Each affects beneficiaries differently. Income tax generally applies to distributions from pre-tax retirement accounts such as traditional IRAs and 401(k)s. Beneficiaries report these distributions as ordinary income and pay federal, and sometimes state, taxes. Estate tax is levied on the decedent's estate before assets pass to heirs, affecting large estates exceeding the federal exemption. Inheritance tax may apply in certain states, depending on the beneficiary and asset type.

Retirement account distributions are generally not subject to federal inheritance tax, but the income they generate can be taxable. Most states do not impose inheritance tax on retirement income, though a few still do. Recognizing these distinctions helps beneficiaries plan withdrawals and avoid surprises at tax time.

Recent Law Changes That Affect Inherited Accounts

Tax rules for inherited accounts have changed substantially with the SECURE Act of 2019, SECURE Act 2.0 in 2022, and IRS final regulations from 2024, effective in 2025. These updates directly affect how inherited IRA accounts are taxed and which strategies heirs can use to manage distributions and tax exposure.

The SECURE Act eliminated the "stretch IRA" for most non-spouse beneficiaries, replacing it with a 10-year rule that requires inherited accounts to be fully distributed within ten years of the original owner's death. SECURE Act 2.0 clarified RMD rules, Roth account treatment, and penalties, giving beneficiaries clearer guidance on how and when to take distributions. Roth accounts in employer-sponsored plans, for example, are no longer subject to RMDs during the account owner's lifetime, aligning them with Roth IRAs.

Required Minimum Distributions (RMDs) After Death

Required Minimum Distributions are a key factor in taxes on inherited accounts. They dictate when distributions must begin and how much must be withdrawn, affecting income taxes for beneficiaries.

The current RMD schedule under SECURE Act 2.0 is as follows:

These changes allow account owners to keep funds invested longer, potentially increasing retirement savings while deferring tax liabilities.

The 10-Year Rule

Most non-spouse beneficiaries must follow the 10-year rule, requiring full withdrawal of the inherited account within ten years. IRS final regulations issued in 2024 clarified the application. If the original owner died before their RMD start date, beneficiaries can take distributions at any time within the 10-year period without annual RMDs. If the original owner died on or after their RMD start date, annual RMDs are required for years one through nine, and the account must be fully depleted by year ten. These rules are fully enforceable starting in 2025, following prior penalty waivers between 2021 and 2024.

The penalty for missing an RMD has been reduced. Previously, missed RMDs were subject to a 50% penalty; this has been lowered to 25% and can be further reduced to 10% if the missed distribution is corrected within two years.

Spouse and Non-Spouse Beneficiaries

Tax treatment of an inherited account depends heavily on the relationship to the decedent. Spouses have the most flexibility. They can treat an inherited IRA as their own, rolling it into their account and delaying RMDs until their own required age. Alternatively, spouses may remain the account's beneficiary and follow life-expectancy RMD rules, which in some cases provides a more favorable distribution schedule.

Non-spouse beneficiaries have fewer options. They cannot treat an inherited account as their own and must follow stricter IRS rules. They can transfer funds into an inherited IRA, take a lump-sum distribution, or leave funds in the account and withdraw over ten years. Special cases—such as chronically ill or disabled beneficiaries, minor children under age 21, or beneficiaries not more than ten years younger than the decedent—may allow life-expectancy distributions rather than the standard 10-year timeline. Minor children must switch to the 10-year rule once they reach 21.

Taxes on Traditional IRAs and Employer-Sponsored Plans

Withdrawals from traditional IRAs and pre-tax employer plans like 401(k)s, 403(b)s, and 457(b)s are taxed as ordinary income. Filers must report the amount withdrawn as gross income for the year received. Roth IRAs and Roth 401(k)s are typically tax-free when they meet qualified distribution rules. Inherited Roth accounts, however, must follow the 10-year rule, and distributions must be taken within that window to avoid penalties.

Step-Up in Basis for Non-Retirement Assets

Inheriting taxable investment accounts like stocks or real estate offers a key tax advantage. Assets receive a step-up in basis to their value at the decedent's date of death, which can significantly reduce capital gains taxes when sold. For instance, if inherited stock is valued at $100,000 at the time of inheritance and sold later for $120,000, the capital gain is calculated only on the $20,000 increase. However, retirement accounts do not receive a step-up in basis, making distributions fully taxable as ordinary income.

Federal and State Estate Taxes

Federal estate tax applies to estates above $15 million per person in 2026. The exemption is now permanent and inflation-adjusted under the One Big Beautiful Bill (OBBB) Act, which superseded the prior sunset that would have cut the exemption to about $7 million. Retirement accounts count toward total estate value and can determine whether federal estate tax applies, even though heirs still owe income tax on pre-tax account distributions.

As of 2026, five states impose inheritance taxes: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Iowa's inheritance tax was fully repealed for deaths occurring on or after January 1, 2025.

Maryland is unique because it is the only state that collects both estate and inheritance taxes. Maryland's estate tax has a $5 million exemption, and its inheritance tax is a full 10% flat rate on non-exempt beneficiaries such as nieces, nephews, friends, and more distant relatives. New Jersey repealed its estate tax in 2018, but its inheritance tax remains fully in effect.

Twelve states plus Washington, D.C., levy estate taxes: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington, plus the District of Columbia. Connecticut's exemption aligns with the federal exemption and is capped at $15 million; Connecticut is also the only state with a state-level gift tax. State rules differ and can change, so heirs of large IRAs or other inherited accounts should review both federal and state rules before deciding on distributions.

Strategies to Minimize Taxes on Inherited Accounts

Sound tax planning can help you keep more of an inheritance. Spreading withdrawals over the 10-year window instead of taking a lump sum can keep you out of higher brackets. Original owners can also convert traditional IRAs to Roth IRAs in low-income years to shrink future taxable distributions for heirs. Charitable strategies can cut estate and income taxes, and qualified charitable distributions (QCDs) work especially well with IRAs. Trusts can help manage distributions, bypass probate, and lower tax exposure, but expert advice is essential for compliance.

Reporting and Compliance

All distributions from inherited accounts must be reported on the beneficiary's tax returns, typically using forms such as 1099-R. Maintaining accurate records of account statements, RMDs, and transfers is essential to comply with IRS regulations. Misreporting distributions can result in penalties and interest.

How Valor Tax Relief Can Help

Handling taxes on inherited accounts can feel overwhelming, especially with IRS rules, distribution deadlines, and possible penalties in the mix. Many heirs are surprised by how quickly a mistake with inherited IRAs or retirement accounts can lead to unexpected tax bills. Expert guidance can help protect the value of what you inherit.

If inherited account distributions have already created a tax burden, Valor Tax Relief may be able to assist with resolution options such as installment agreements, penalty abatements, or other IRS relief programs when appropriate. Getting help early can reduce stress and improve your financial outcomes.

Frequently Asked Questions