What Is an Inheritance? Meaning, How It Works and Taxes

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An inheritance is the money, property and other assets a person receives after someone dies. The recipient may inherit as an heir under state law or as a beneficiary named in a will, a trust, a retirement plan or a life insurance policy. Depending on where the person who died (the decedent) lived and how the recipient is related to them, an inheritance may be subject to inheritance tax, estate tax or neither.

How an Inheritance Works

When someone dies, everything they owned and everything they owed becomes their estate. Before anyone inherits, the estate has to settle the decedent’s debts, final bills, taxes and administration costs. What remains is distributed to the people entitled to it.

Assets reach recipients by one of two routes:

• Probate assets are held in the decedent’s name alone with no named beneficiary. They are distributed under the will or, if there is none, under state law, with a court overseeing the process.
• Non-probate assets pass directly to a named person without going through the will. Common examples are life insurance policies, retirement accounts with beneficiary designations, payable-on-death bank accounts, property held in joint tenancy with right of survivorship and assets held in a trust fund.

A beneficiary designation on an account generally controls who receives that account even if the will says something different. This is why an outdated designation, such as an ex-spouse still listed on a retirement plan, can send money somewhere the decedent no longer intended.

The Probate Process

Probate is the court-supervised process that confirms a will is valid and authentic and then administers the estate. If there is a will, the court appoints an executor, usually the person the will names, who gathers assets, notifies creditors, pays valid debts and distributes what is left to the people named in the will. Disputes, such as a challenge to the will’s validity or a disagreement among family members, are resolved in probate court.

A person who dies without a will, or with a will the court finds invalid, has died intestate. The court then appoints an administrator, who divides the assets under the state’s intestate succession rules, typically starting with a surviving spouse and children and moving outward to parents, siblings and more distant relatives.

Beneficiaries vs. Heirs

The two terms are often confused but describe different legal positions:

• A beneficiary is someone named to receive property in a will, trust, insurance policy or account designation. A beneficiary does not have to be a relative; it can be a friend or a charity.
• An heir is someone entitled to receive property under intestate succession, the default rules that apply when there is no valid will.

A child can be both: an heir under state law and a beneficiary under a parent’s will. A close friend named in a will is a beneficiary but not an heir.

How Inheritances Are Taxed

Three different taxes can touch an inheritance, and they fall on different people.

Inheritance Tax

An inheritance tax is a state tax charged to the person who receives the assets. The federal government does not levy one. Among U.S. states, only Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania do.

The amount owed depends on the recipient’s relationship to the decedent, the value received and the state’s rules. Surviving spouses are typically exempt, children may be exempt or taxed at lower rates, and people with no family tie generally face the highest rates. In Nebraska, for example, close relatives such as parents, grandparents, siblings, children and other lineal descendants (including adopted children) have paid 1% on amounts above $100,000, while remote relatives have paid up to 11% on amounts above $40,000. Life insurance proceeds are not subject to inheritance tax.

Estate Tax

An estate tax is charged on the estate itself, before assets are distributed, and is paid by the estate rather than the recipient. The federal government and some states impose one, each with its own exemption threshold, so only estates above the threshold owe it. Assets left to a spouse or to qualifying charities are generally deductible from the federal estate tax.

Income Tax

Inherited cash and property are generally not taxable income to the recipient at the federal level. Income tax enters in two places:

• Investments and property: Inherited assets usually receive a “stepped-up” cost basis equal to their market value at the date of death. If the recipient later sells, the capital gain is measured from that value, not from what the decedent originally paid.
• Pre-tax retirement accounts: Withdrawals from an inherited traditional IRA or 401(k) are taxable income to the beneficiary, just as they would have been to the original owner.

Example of an Inheritance

Hypothetical example for illustration only. Maria dies with a will leaving her house to her son and her brokerage account to her niece. She also has a life insurance policy naming her son as beneficiary.

1. The life insurance payout goes directly to her son, outside probate.
2. The house and brokerage account go through probate. The executor uses estate cash to pay Maria’s remaining credit card balance, funeral costs and court fees.
3. Maria bought the house for $150,000, and it is worth $400,000 when she dies. Her son’s cost basis steps up to $400,000. If he sells it for $410,000, his taxable gain is $10,000, not $260,000.
4. If Maria lived in a state with an inheritance tax, her son, as a lineal descendant, would likely pay a low rate or none, while her niece, a more distant relative, could owe a higher rate on her share.

Inherited 401(k)s and IRAs

A surviving spouse who inherits a 401(k) can take a lump sum, which triggers income tax on the full amount, or defer taxes by rolling the money into their own retirement account or into an inherited IRA. Taxes are then owed only as distributions are taken.

A non-spouse beneficiary, such as an adult child, has fewer choices, depending on what the plan allows: usually a lump sum or a rollover into an inherited IRA, followed by the required distribution schedule. Since the SECURE Act took effect in 2020, most non-spouse beneficiaries must empty an inherited account within 10 years, which can push large withdrawals into high-income years if not spread out.

Reducing Taxes on an Inheritance

Most planning to lower inheritance taxes is done by the person leaving the assets. Common approaches include:

• Trusts: Placing assets in a trust can move them outside probate and, depending on the structure, change how they are taxed.
• Lifetime gifts: Giving assets to beneficiaries while still living reduces the size of the estate, subject to federal gift tax rules.
• Life insurance: Naming heirs as beneficiaries of a policy passes money that is not subject to inheritance tax.

Gifting carries a tradeoff: an asset given during life keeps the giver’s original cost basis, while an asset inherited at death usually receives a stepped-up basis.

Limitations and Risks

• Debts come first. Creditors are paid from the estate before distributions. Heirs are generally not personally responsible for a decedent’s debts, but an estate with large debts can leave little or nothing to inherit.
• Probate takes time and money. Court and administration costs reduce the estate, and contested wills can delay distributions.
• Bankruptcy. An inheritance you become entitled to within 180 days after filing for bankruptcy generally becomes part of the bankruptcy estate, and a Chapter 13 trustee may require it to be paid into your plan. For inheritances received later in a Chapter 13 plan, most courts have required the money to go to creditors, though some have let the debtor keep it.
• Spending risk. A large windfall can raise net worth quickly, but property such as real estate also brings ongoing costs like taxes, insurance and maintenance.

FAQs

The Bottom Line

Anyone expecting to inherit, and anyone planning their own estate, should know which assets pass through probate and which pass directly to named people. Keeping beneficiary designations current, understanding the stepped-up basis, and planning withdrawals from inherited retirement accounts can reduce taxes and surprises. Debts, probate costs and state inheritance tax rules can all shrink what recipients actually receive.