Protecting Your Legacy: Understanding Inheritance Taxes

When planning for the future, one important question is often overlooked: will your loved ones have to pay taxes on the assets you leave behind? The answer isn’t simple. It depends on several factors, including the types of assets you own, the total value of your estate, and the state where you live at the time of your death. Understanding how different assets are taxed can help you make informed decisions and potentially reduce the financial burden placed on your beneficiaries.

In this article, I’ll explain how various types of inheritances — from cash accounts to retirement plans — are treated for tax purposes, helping you plan strategically and preserve more of your wealth for the people you care about most.

Will Estate Taxes Apply?

There are three things no amount of planning can fully predict: when you will pass away, what your assets will be worth at that time, and what the federal estate tax exemption will be when that day comes. Over the past 25 years, the federal estate tax exemption has fluctuated dramatically — from as low as $675,000 to as high as today’s $15 million per person.

As of 2026, federal estate tax generally applies only to estates exceeding $15 million for individuals or $30 million for married couples. If your estate falls below these thresholds, no federal estate tax is owed. However, if the value of your estate exceeds the exemption amount, taxes must be paid before your beneficiaries receive their inheritances. For married couples, it is especially important to review and update an estate plan after the first spouse’s death to ensure the full exemption of both spouses is properly preserved and utilized.

It’s also important to remember that some states impose their own estate or inheritance taxes, often with much lower exemption amounts. A comprehensive estate plan must account for both federal and state tax rules.

Finally, estate taxes are only one piece of the puzzle. Income taxes and capital gains taxes can also significantly affect what your beneficiaries ultimately receive (and while trust taxation may apply as well, that topic deserves its own discussion in a future article). Even though estate planning focuses on what happens after death, effective planning requires a strategy tailored to each type of asset you own.

With that framework in mind, let’s look at how different assets are taxed when they pass to your loved ones.

Cash and Bank Accounts: The Simple Answer

When your beneficiaries inherit cash from checking accounts, savings accounts, or money market accounts, they receive favorable tax treatment. If you leave someone $50,000 in your savings account, they receive the full $50,000 without federal income tax consequences.

There's one small exception to note. If your account earns interest after your death but before distribution, that interest becomes taxable income to the beneficiary. However, the principal amount itself remains tax-free.

This straightforward treatment makes cash accounts one of the most tax-efficient assets to inherit, which is why many estate plans include liquid assets alongside other investments.

Investment Accounts: The Step-Up in Basis Advantage

Taxable investment accounts, including brokerage accounts holding stocks, bonds, or mutual funds, benefit from what's called a "step-up in basis." This tax provision can save your beneficiaries a significant amount of money.

Here's how it works. When you purchase an investment, your "basis" is typically what you paid for it. If you bought stock for $10,000 and it grew to $100,000, you'd normally owe capital gains tax on that $90,000 gain if you sold it. However, when your beneficiaries inherit that stock, their basis "steps up" to the fair market value at your death, which is $100,000 in this example. If they immediately sell it for $100,000, they owe no capital gains tax at all. However, if they sell it later and the stock has appreciated, they will owe capital gains tax - but only on the amount above $100,000.

This step-up in basis is one of the most powerful tax benefits in estate planning, effectively erasing all capital gains that accumulated during your lifetime. Your beneficiaries only pay capital gains tax on appreciation that occurs after they inherit the asset.

Understanding this benefit can influence your gifting strategy. Sometimes it's more tax-efficient to hold appreciated assets until death rather than gifting them during your lifetime, when the recipient would inherit your lower basis, and therefore pay taxes on capital gains incurred via a sale after the gift of the asset.

Retirement Accounts: A More Complex Picture

Retirement accounts like 401(k)s and traditional IRAs present more complicated tax considerations. Unlike other inherited assets, these accounts don't receive a step-up in basis, and they come with income tax obligations.

When your beneficiaries inherit a traditional retirement account, they must pay ordinary income tax on distributions. If you had $500,000 in your IRA and your daughter inherits it, she'll owe income tax on every dollar she withdraws. The tax rate depends on her income bracket, which means careful withdrawal planning becomes essential.

The SECURE Act of 2019 (and amended in 2022) changed the rules significantly for most beneficiaries. Previously, non-spouse beneficiaries could "stretch" distributions over the balance of the rest of their lifetime, which can have significant tax benefits, keeping beneficiaries in a lower tax bracket and deferring taxes over a longer period of time. Now, in most cases, all retirement benefits must be paid to your beneficiaries (and taxed for income tax purposes) within 10 years of your death. This compressed timeline can push beneficiaries into higher income tax brackets if they're not strategic about timing their withdrawals.

Spouses who inherit retirement accounts have more flexibility. They can roll the inherited account into their own IRA, allowing them to defer distributions until they reach the required minimum distribution age.

Roth IRAs offer a distinct advantage. While beneficiaries still face the 10-year distribution rule, qualified Roth IRA withdrawals are tax-free. If you've paid taxes upfront by contributing to a Roth account, your beneficiaries receive the funds without owing any income tax.

Life Insurance: Generally Tax-Free

Life insurance death benefits typically pass to beneficiaries income-tax-free, making them an excellent estate planning tool. If you have a $1 million life insurance policy, your beneficiary receives the full $1 million without paying income tax on it.

There's an important caveat regarding estate taxes. If you own the policy on your own life, the death benefit may be included in your taxable estate. For very large estates, this could trigger estate taxes even though the beneficiary won't owe income tax. Advanced planning strategies, such as irrevocable life insurance trusts, can remove life insurance from your taxable estate.

Strategic Planning Makes All the Difference

Understanding how different assets are taxed when inherited allows you to structure your estate strategically. You might choose to leave tax-efficient assets like cash or appreciated stocks to certain beneficiaries while directing retirement accounts to others who can better manage the tax consequences.

As your Personal Family Lawyer® Firm, we help you create a Life & Legacy Plan that considers not just what you're leaving behind, but how to structure your assets to minimize taxes and maximize what your loved ones receive. Tax laws change frequently, and your circumstances evolve over time, so having ongoing, strategic guidance makes all the difference between a plan that works when your loved ones need it to. That’s where we come in. 

Don't leave your beneficiaries struggling with unexpected tax bills. Click here to schedule a complimentary 15-minute discovery call and learn how I can support you.