Exploring the Financial Implications of Paying Taxes on Inheritance

Many people assume that receiving an inheritance automatically means paying taxes on that money. But do you pay taxes on inheritance? In reality, the tax treatment of inherited assets is often more nuanced and depends on the type of asset received, the estate's location, and how the funds are distributed.

At C.E. Thorn, our Raleigh tax prep CPAs regularly work with clients who are navigating inherited assets and the tax questions that come with them. Understanding how inheritance may affect your tax situation can help you make more informed decisions and avoid surprises when it comes time to file your return.

Understanding Estate and Inheritance Taxes

Before we can answer "Do you pay taxes on inheritance?" we have to define the difference between estate and inheritance taxes. The terms estate tax and inheritance tax are sometimes used interchangeably, but they refer to two different types of taxes that may apply when assets are transferred after someone’s death. The key distinction is who is responsible for paying the tax and when the tax is assessed during the estate settlement process.

Key Difference Between Estate vs Inheritance Taxes

While both taxes relate to the transfer of wealth after death, the key distinction is who pays the tax:

• Estate tax: Paid by the estate before assets are distributed to beneficiaries.
• Inheritance tax: Paid by the beneficiary who receives the inherited assets.

Estate Tax Rules

These assets may include:

• Real estate
• Bank account balances
• Investment accounts
• Business interests
• Retirement accounts
• Life insurance policies
• Personal property

Estate Tax Rates

If an estate exceeds the federal exemption threshold, the portion above that limit may be taxed using progressive federal estate tax rates that can reach up to 40%. The exact estate tax liability depends on the size of the taxable estate and the deductions available under federal tax law. Because the tax is applied at the estate level, beneficiaries typically receive assets after any required estate tax obligations have been addressed.

Inheritance Tax Rules

An inheritance tax is assessed on the individual receiving the inheritance, rather than on the estate itself. In states that impose this tax, each beneficiary may be responsible for paying tax on the value of assets transferred to them.

Inheritance tax rules vary by state and often depend on the beneficiary’s relationship to the deceased person. Spouses and close family members frequently receive exemptions or lower tax rates, while more distant relatives or unrelated heirs may face higher rates.

Currently, only a small number of states impose an inheritance tax, including:

• Iowa
• Kentucky
• Maryland
• Nebraska

Inheritance Tax Rates

Inheritance tax rates can vary depending on both the state and the relationship between the beneficiary and the deceased individual. In some states, close family members may pay little or no tax, while more distant beneficiaries may face higher tax rates based on the value of the inherited assets.

Because North Carolina does not levy an inheritance tax, most residents receiving transferred assets do not face a state-level inheritance tax when property, investments, or cash are transferred to them.

How Federal Taxes Apply to Inherited Assets

Many people assume that receiving an inheritance automatically means paying federal taxes on the money or property they receive. In reality, the federal tax treatment of inherited assets depends on several factors, including the size of the estate, the type of asset inherited, and whether the beneficiary later sells or earns income from those assets.

In most cases, beneficiaries do not pay federal income tax simply for receiving an inheritance. Instead, federal taxes may apply at the estate level before assets are distributed, or later when inherited property generates income or is sold.

Federal Estate Tax May Apply to Large Estates

The federal government may impose an estate tax on very large estates before assets are transferred to beneficiaries. This tax applies to the total value of a deceased person’s estate, including real estate, investments, and other assets.

Income Taxes May Apply to Certain Inherited Assets

While receiving inherited cash is typically not taxable, some inherited assets may generate taxable income after they are transferred to the beneficiary.

Examples include:

• Inherited retirement accounts, which may require taxable withdrawals
• Rental properties, where ongoing rental income may be subject to income tax
• Investment accounts, where dividends or interest earned after inheritance may be taxable

These taxes apply to income generated after the inheritance, rather than to the inheritance itself.

Capital Gains Tax May Apply When Assets Are Sold

If you inherit investments or property and later sell them, capital gains tax may apply to the profit from that sale. However, many inherited assets receive what is known as a “step-up in basis,” which adjusts the asset’s value to its fair market value at the time of the original owner’s death.

Because of this rule, beneficiaries typically pay capital gains tax only on appreciation that occurs after the inheritance. For example, if you inherit stock worth $100,000 and later sell it for $120,000, the taxable gain may apply only to the $20,000 increase in value after the inheritance.

How North Carolina Handles Inheritance Taxes

While federal tax rules often receive the most attention, state estate tax can also affect inherited assets. The good news for North Carolina residents is that the state no longer imposes an inheritance tax on beneficiaries.

Beneficiaries Generally Do Not Pay State Inheritance Tax

In states that impose inheritance taxes, the beneficiary may be required to pay tax on assets received from an estate. Because North Carolina eliminated its inheritance tax in 2013, beneficiaries typically do not face that type of state-level tax when assets are transferred.

This means inherited assets such as:

• Cash distributions
• Investment accounts
• Real estate or inherited property

Other State Taxes May Still Apply in Certain Situations

Although North Carolina does not have an inheritance tax, other tax considerations may still apply depending on how inherited assets are handled.

For example:

• Income generated from inherited investments may be subject to state income tax
• Selling inherited property may create capital gains tax on appreciation after inheritance
• Business income from inherited assets may need to be reported on a state return

Because inheritance situations can involve multiple types of assets and tax rules, the exact tax outcome can vary depending on the circumstances.

Inheritance Tax FAQs

Are inherited assets considered taxable income?

Generally, inherited assets like inherited cash, property, or investments are not considered taxable income. However, income from those assets, such as dividends or withdrawals from certain accounts, may be included in gross income.

Do you pay capital gains tax on inherited property?

If you sell inherited property or inherited stocks, you may owe capital gains tax on any increase in value after the inheritance. The gain is usually calculated using the stepped up basis, which adjusts the cost basis to the fair market value at the date of death.

What does “step-up in basis” mean for inherited assets?

A stepped up basis means the inherited basis of property is typically reset to its fair market value at the decedent’s death, rather than the original purchase price. This rule may reduce future capital gains if the asset is sold soon after inheritance.

How are inherited retirement accounts taxed?

Withdrawals from retirement accounts, such as a traditional IRA, may be treated as taxable income because the accounts were often funded with pre-tax dollars. In many cases, retirement account distributions must occur within a set time period depending on the beneficiary.

Do life insurance payouts count as taxable inheritance?

Proceeds from life insurance policies are typically not considered taxable income when paid to beneficiaries. However, if the policy is owned by the decedent’s estate, it may still affect the value of the taxable estate for estate tax purposes.

Can estate planning reduce the tax burden on inherited assets?

Thoughtful estate planning may help manage the potential tax burden on heirs and reduce complications when assets are transferred.

Should I speak with a tax professional about inherited assets?

Inheritance situations can involve multiple rules related to income taxes, capital gains taxes, and estate or inheritance taxes. Seeking advice from a qualified tax professional or estate planning attorney may help clarify reporting obligations, tax planning options, and estimated taxes.

Contact Our Raleigh CPAs to Learn More About Staying Compliant

If you recently received inherited assets or are navigating tax questions related to an estate, our team may be able to help clarify the rules that apply. Reach out to the small business accountants at C.E. Thorn, CPA, PLLC, to discuss your situation and learn more about staying compliant with current tax requirements.

Get started by calling  919-420-0092 or filling out the form below.