When a loved one passes away, one of the assets you might inherit is an investment account. Sometimes, this is an investment account that doesn’t carry the restrictions of a retirement account, called a taxable account. Other times, it’s an individual retirement account or IRA. You might be familiar with these investment vehicles, but if you’ve inherited one, you need to increase your understanding of how they work.
In this article, we’ll look at the differences between taxable accounts and IRAs, both traditional and Roth. In addition to looking at the different tax statuses and barriers to access, we’ll see how distributions differ when an account is inherited.
A taxable account is an investment account that lets you grow your assets without the restrictions of a retirement account. Contributions to retirement accounts are tax-deferred, meaning money is put into these accounts before income tax is applied.
In contrast, contributions to taxable accounts are made after income taxes have been paid, which makes these accounts far more flexible. You can invest in stocks and mutual funds to grow your money, and there are no barriers to taking money out of taxable accounts. There are also no limits to how much money you can put in.
Taxable accounts are subject to two types of tax, the first of which is capital gains. Say you buy a stock for $100, and three years later, you sell it for $500. The $400 growth gets taxed as income, but it’s treated at the capital gains tax rate.
At 15 percent, this capital gains tax rate is lower than most people’s income tax rate, which ranges from 10 percent to 37 percent.
The second tax is a tax on your dividends or your interest. Income from dividends is reported as normal income and taxed at your regular income tax rate.
In this dual tax identity, the capital gains tax on growth is typically the larger part of the tax you pay on a taxable account. The taxes on gains and losses only come into play when you’ve actually sold an investment.
If you sell stock at a loss, you can use that loss to reduce your income. There are some minutiae with these strategies, but as an example, if you have a $500 gain on one stock and a $500 loss on another, they offset each other and there’s no impact on your taxes.
There is a limit to how much loss you can report on your taxes each year if you do not have an offsetting capital gain: $3,000.
If you took a $30,000 loss one year but didn’t sell other stocks at a gain, you could claim $3,000 of that loss per year on your taxes to reduce your taxable income. A loss like this can be a valuable tax planning tool, even if you make no money on a taxable account.
While inheriting a retirement account comes with rules about when you need to take distributions, there are no rules of distribution for inheriting a taxable account.
When taxable accounts are inherited, they receive a step-up in cost basis. The cost basis of an investment is the original amount paid for the stock. When the stock grows and its value changes after purchase, the gain is the difference between the original amount paid and the present-day amount after growth. When the cost basis “steps up,” the base value of the stock becomes the current-day value on the date of death.
As an example, let’s say your grandfather bought Ford stock fifty years ago when it was $3 per share. Today, it’s worth $60 per share. If you were to sell that stock before his death, there would be a huge capital gain tax waiting for you. However, the step-up in cost basis means that the stock’s value on the day of death becomes the new cost basis.
The capital gains tax would no longer be calculated off the $3 per share from your grandfather’s day, but rather from the $60 per share value when you inherited it.
The Huge Capital Gain Tax Gets Wiped Away.
You now own the stock, and when you sell it, your gains will be calculated by how much it grew from the $60 per share price on the day you inherited it.
This means that inheriting stock in a taxable account creates a beautiful opportunity to diversify investments. You have a lot of flexibility to sell.
Before you do, it’s important to make sure that the account value is properly stepped up on a cost basis. The institution handling the account can take care of this easily, and they’ll need a copy of the death certificate, so they have the date of death to calculate the new cost basis. They won’t step up the cost basis automatically, however, so it’s important to make sure the step up is documented before you sell an inherited stock.
This type of account is set up specifically to save and invest money for retirement. The tax structure and distribution rules of traditional IRAs are designed to grow wealth long term and discourage taking money out before retirement age.
When you make contributions to a traditional IRA, you generally receive a tax deduction. However, there is a limit to how much you can contribute to this type of account per year. As of this writing, it’s $6,000 if you’re under fifty, and $7,000 if you’re over fifty.
Not only do you get a tax deduction for putting money into an IRA, but once the money is invested in the account, it grows tax-deferred, meaning you don’t pay taxes on those funds in the time that you hold the investment. The money in an IRA continues to grow and grow, and taxes are taken only when you take money out as a distribution.
Because money in an IRA is intended for retirement, penalties apply if you take money out before the age of fifty-nine and a half. Standard federal and state taxes apply if you take distributions early, and additionally, a 10 percent penalty will be taken from the value of the distribution. In all, it’s about a 45 percent loss of value to taxes for most people.
Once you hit age fifty-nine and a half, you can take as much distribution as you want, and you’ll pay federal and state income taxes on what you receive.
From age seventy and a half on, you are required to take a minimum distribution from your IRA, as calculated by a federal formula.
Income taxes are higher for most people than the capital gains tax rate, so it’s good to have a mix of taxable accounts and IRAs to preserve and grow your wealth.
When inheriting an IRA, there are a few quirks to the distribution rules, depending on how the heir handles the account they receive.
When a spouse inherits an IRA, they have the option to treat the IRA as their own, and this comes with its own rules. In this case, the spouse would designate themselves as the new account owner, and they can manage and contribute to the account.
The distribution requirement is based on the age of the person who died, not the person who inherits the account. This means that if one spouse died at the age of sixty, but the surviving spouse is fifty-five, the surviving spouse could start taking the distribution penalty-free because the deceased spouse was at the age to qualify.
It also means that the clock continues when the minimum distribution requirement kicks in. When the deceased spouse would have turned seventy and a half, the surviving spouse is required to start taking out minimum distributions.
This time period, between when distributions are allowed (beginning at age fifty-nine and a half) to when they are required (at age seventy and a half) is a “freedom zone.” Based on how the surviving spouse wishes to take distributions in this range, and whether they want to calculate distributions off their spouse’s age or theirs, they can treat the deceased spouse’s IRA as their own or transfer the funds to their account.
Transferring the funds into a new account in the surviving spouse’s name can be a useful way to reset the distribution rules. In an example with one client, her older spouse died, and she was required to take distributions that were much higher than she would normally take for herself. She didn’t need the money, and this resulted in her paying higher taxes than she needed to. We changed the account into her name, so the standard IRA distribution rules would apply based on her age, not her husband’s.
This strategy relieves the tax burden of the distributions and gives the heir freedom to wait until age seventy and a half to begin taking money out.
Lastly, survivors who aren’t spouses need to create an Inherited IRA from the deceased’s account. Spouses can take this option as well, and, depending on how they would like their distributions structured, it may be a better option than creating a new account in their name. The minimum required distribution that a beneficiary must take from an Inherited IRA is very specific and dependent on the beneficiary’s age.
This figure is calculated with a table from the IRS called the Single Life Table for Inherited IRAs, and it is determined by the beneficiary’s age at the time of inheritance, adjusting with their age throughout their lifetime. The table can be found on the IRS website, and a financial advisor or investment broker can help you calculate the exact amount you’re required to take if you’ve inherited an IRA.
A Roth IRA is a different animal from a traditional IRA.
It has a unique tax treatment and no required distributions until inherited, which makes this type of account a lovely legacy planning tool to pass down to heirs.
Like a taxable account, you do not get a tax deduction for contributing to a Roth IRA; money is put into this type of account after income tax has been applied.
The limits to how much you can contribute are the same as a traditional IRA: $6,000 per year, or $7,000 per year after the age of fifty. The genius and beauty of a Roth IRA are that money in this type of account grows tax-deferred just like it would in a traditional IRA, but when money is distributed from a Roth IRA, the distribution is tax-free.
Similar to a taxable account, there is no required distribution from a Roth IRA.
You must be fifty-nine and a half to take distributions from a Roth IRA without penalty, and additionally, the account has to have been open (though not necessarily funded) for at least five years before taking a distribution.
When a Roth IRA is inherited, the heir can stretch distributions out over their lifetime, and they don’t pay taxes on the money they receive. There are also no penalties for taking money out early when the account is inherited.
For more advice on evaluating an inherited investment account, you can find Inheriting Chaos with Compassion on Amazon.
Jennifer Luzzatto is a Chartered Financial Analyst®, a Certified Financial Planner®, and a NAPFA registered financial advisor. She began her career in financial services thirty years ago as a fixed-income trader in a regional brokerage firm and went on to manage personal trust accounts, institutional portfolios, and a municipal bond mutual fund at a commercial bank. In 1999, she founded Summit Financial Partners, transitioning from banking to financial planning and investment advisory services. Jennifer holds a BA in Psychology and an MBA from the University of Richmond. She lives in Richmond, Virginia, with her daughter and their dog.