You may be wondering whether your children will owe capital gains taxes on the assets they inherit. The good news is that most inherited assets receive a step-up in basis, which will typically eliminate liability.
However, other tax considerations may still come into play. Understanding how taxes affect inheritances can help you structure your estate to minimize financial burdens for your heirs.
The Step-Up in Basis and Capital Gains Tax
When someone inherits an asset, the IRS applies a step-up in basis, which adjusts the asset’s value for tax purposes. The new cost basis is set at the fair market value of the asset on the date of inheritance.
This step-up eliminates taxable gains on any appreciation that occurred before inheritance.
For example, let’s say you purchased a home for $200,000 and it is worth $500,000 when your children inherit it. Their basis for capital gains tax purposes is $500,000.
If they sell it for that amount, there is no taxable gain. If they hold onto it and later sell it for $550,000, they would get a big break. Your children would only owe capital gains tax on the $50,000 increase in value.
The step-up in basis applies to assets such as real estate, stocks, and other investments. However, it does not apply to certain tax-deferred accounts, which are treated differently when inherited.
Inheritance and Income Taxes
While most inherited assets are not subject to income tax, some exceptions exist. If your children inherit a traditional IRA, 401(k), or annuity, they will owe income tax on withdrawals.
These accounts are funded with pre-tax dollars, meaning that any distributions taken after inheritance are considered taxable income.
Inherited trust income is also subject to income tax. Once a trust becomes irrevocable after the grantor’s death, any earnings generated by trust assets—such as interest, dividends, or rental income—may be taxed.
If income remains in the trust, it is taxed at trust income tax rates, which are typically higher than individual rates. However, if the income is distributed to beneficiaries, they report it on their personal tax returns and pay taxes at their individual rates.
Connecticut Estate and Gift Taxes
In addition to federal estate tax considerations, Connecticut imposes a separate estate tax. This year, Connecticut’s estate tax exemption is $13.99 million, mirroring the federal exclusion.
In addition, Connecticut is the only state in the union with a state-level gift tax, and the $13.99 million exemption applies to gifts as well. If you give away more than the excluded amount over your lifetime, any additional gifts are subject to the Connecticut gift tax.
If your estate is going to be exposed to estate taxes, you can take steps to mitigate the burden. Certain types of irrevocable trusts are used to gain estate tax efficiency, and you can consider additional transfer strategies that can be part of a broader plan.
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And aside from the info you can find here, we get out into the community hosting seminars. The sessions cover all the most important topics and are offered on a complimentary basis.
To see the dates and obtain registration information, visit this page: Westport/Glastonbury, CT Estate Planning Seminars Schedule.
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