Inheritance Taxes Explained: What Really Matters

When you’re planning for what happens after you’re gone, there’s one question that often gets overlooked but matters deeply to your beneficiaries: will they owe taxes on what you leave them?

The honest answer? It depends. It depends on the type of assets you’re passing down, the total value of your estate, and even where you live at the time of your death. Not all inheritances are taxed the same way, and understanding those differences can help you make smarter decisions now so your loved ones keep more of what you intended for them.

In this article, I’ll walk you through how different assets are taxed from bank accounts to retirement plans so you can plan strategically and protect more of your wealth for the people you love.

Will Estate Taxes Apply to You?

No matter how thoughtful or proactive your planning is, there are three things no one can predict with certainty: when you’ll die, what your assets will look like at that time, and what the federal estate tax exemption will be then. History proves just how much that last piece can swing, the federal exemption has ranged from well under $1 million to well into the multi-millions per person over the past few decades.

What matters most is this: federal estate tax only applies if your estate exceeds the exemption amount in effect at your death. If it doesn’t, there’s no federal estate tax due. If it does, taxes must be paid before your beneficiaries receive anything. And if you’re married, it’s critical that planning is reviewed and updated after the first spouse dies so the full exemption of both spouses is preserved. Miss that step, and you could unintentionally lose a significant tax benefit.

It’s also important to remember that federal rules aren’t the whole story. Some states impose their own estate or inheritance taxes and often at much lower thresholds. That’s why comprehensive planning must account for both federal and state tax exposure.

And here’s the part many people miss: estate tax isn’t the only tax in play. Income tax, capital gains tax, and sometimes trust-level taxes all factor into how much your loved ones actually receive. Even though we’re planning for death, the strategy has to be asset-specific because different assets are taxed very differently.

With that framework in mind, let’s look at how various types of assets are taxed when your loved ones inherit them and what smart planning can do to reduce unnecessary tax pain.

Bank Accounts and Cash: The Basics

When your beneficiaries inherit cash from checking, savings, or money market accounts, the tax treatment is refreshingly simple. If you leave someone $50,000 in a savings account, they generally receive the full $50,000, no federal income tax due.

There is one small nuance to be aware of. Any interest the account earns after your death but before the funds are distributed is taxable income to the beneficiary. The original balance, however, remains tax-free.

Because of this clean tax treatment, cash accounts are among the most tax-efficient assets to inherit and are often an important part of a well-balanced estate plan.

Why Investment Accounts Get Special Tax Treatment

Taxable investment accounts like brokerage accounts holding stocks, bonds, or mutual funds come with one of the most powerful (and often overlooked) tax advantages in estate planning: the step-up in basis.

Here’s what that means in real life. Your “basis” is generally what you paid for an investment. So 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.

But when your beneficiaries inherit that same stock, the tax rules shift. Their basis “steps up” to the fair market value on your date of death, $100,000 in this example. If they sell it immediately for $100,000, there’s no capital gains tax at all. If they hold it and it grows to $120,000, they would only owe capital gains tax on the $20,000 of growth that occurred after they inherited it.

In other words, all the appreciation that built up during your lifetime? Wiped out for tax purposes.

This step-up in basis can dramatically reduce the tax burden on your beneficiaries and is a major reason why thoughtful estate planning matters. In some cases, it’s actually more tax-efficient to hold appreciated assets until death rather than gifting them during your lifetime. If you gift the asset while living, the recipient inherits your original (lower) basis and potentially a much bigger capital gains tax bill down the road.

This is where strategy matters. The right plan ensures your investments don’t just grow, they transfer in the most tax-smart way possible.

Retirement Accounts: The Complicated Part

Retirement accounts like 401(k)s and traditional IRAs are where things get more layered. Unlike brokerage accounts, they do not receive a step-up in basis. And yes, income taxes are part of the equation.

When your beneficiary inherits a traditional retirement account, every dollar they withdraw is subject to ordinary income tax. So if you leave behind a $500,000 IRA, that money isn’t tax-free. Your daughter (or whoever inherits it) will owe income tax on each distribution she takes. The rate depends on her income bracket, which means timing withdrawals strategically can make a meaningful difference.

Then came the SECURE Act (2019, with updates in 2022), which significantly changed the landscape. In the past, most non-spouse beneficiaries could “stretch” distributions over their lifetime, spreading out the tax impact and often staying in a lower bracket. Today, in most cases, inherited retirement accounts must be fully distributed within 10 years. That compressed window can push beneficiaries into higher tax brackets if distributions aren’t thoughtfully planned.

Spouses have more flexibility. A surviving spouse can roll the inherited account into their own IRA and delay required distributions until they reach the appropriate age, preserving tax deferral.

Roth IRAs are the bright spot here. While beneficiaries still generally must empty the account within 10 years, qualified Roth withdrawals are income-tax free. If you’ve already paid the tax upfront, your beneficiaries receive those funds without another tax hit.

Why Life Insurance Is Often Tax-Free

Life insurance is one of the most tax-friendly assets you can leave behind. In most cases, life insurance death benefits are paid to beneficiaries income-tax free. If you have a $1 million policy, your loved one generally receives the full $1 million, no income tax due.

There is one important nuance to keep in mind. If you own the policy on your own life, the death benefit may be included in your taxable estate. For families with larger estates, that inclusion could trigger estate taxes, even though the beneficiary still doesn’t owe income tax on the payout.

With proper planning, this issue can often be avoided. Advanced strategies like using an irrevocable life insurance trust can remove the policy from your taxable estate and preserve more of the benefit for the people you love.

Smart Planning Changes the Outcome

Knowing how different assets are taxed when they’re inherited gives you real leverage in your planning. With the right strategy, you can match the right assets to the right people leaving tax-efficient assets like cash or appreciated investments to some beneficiaries, and directing retirement accounts to those best positioned to handle the tax impact.

As your Personal Family Lawyer® Firm, we help you build an Estate Plan that looks beyond what you’re leaving to how it’s structured. Because tax laws change and life never stands still, ongoing guidance is what turns a set of documents into a plan that actually works when your loved ones need it to. That’s exactly where we come in.

If you want to spare your family from unnecessary tax surprises, let’s talk.
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This article is a service of 20WestLegal LLC. We don't just draft documents; we ensure you make informed and empowered decisions about life and death for yourself and the people you love. That's why we offer a Planning Session, during which you will get more financially organized than you've ever been before and make all the best choices for the people you love. You can begin by calling our office in Sudbury, Massachusetts today to schedule an Estate Planning Session and mention this article to find out how to get this $750 session at no charge.

The content is sourced from Personal Family Lawyer® for use by Personal Family Lawyer® firms, a source believed to be providing accurate information. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking legal advice specific to your needs, such advice services must be obtained on your own separate from this educational material.