Are inherited assets taxable?

This is one of the most common questions we receive. Our reply is one of our most common: it depends! Let’s review the elements that come into play when we are discussing the potential taxation of inherited assets blow. Our breakdown is broad but we hope it helps you form a more clear picture of this landscape.

Estate Tax Laws

Most estates are not taxed at the federal level in the United States. As of 2025, the federal estate tax applies only to estates exceeding $13.99 million in value per individual and will increase to $15 million per individual ($30 million per married couple) in 2026 and is indexed for inflation. The estate tax is levied on the total value of the estate, not directly on the assets received by beneficiaries.

There are several states that impose an estate tax and a handful of states that impose an inheritance tax.

Step-up in Basis and Capital Gains Tax

One important tax benefit for inherited assets is the “step-up in basis.” When you inherit assets such as real estate, stocks, bonds, or other investments, their tax basis is generally adjusted to the fair market value on the date of the decedent’s death. This can significantly reduce—or even eliminate—capital gains tax if you later sell the asset.

Example: Three adult children inherit their deceased parents’ home that was originally purchased for $100,000 but is worth $600,000 at the time of inheritance. Their basis is “stepped up” to $600,000 total. If they subsequently sell the home for $630,000 and each receive $210,000, they would each owe capital gain tax on the $10,000 gain ($30,000 total between the three), rather than the $530,000 gain that would apply without the step-up.

Example: Frick inherits an individual stock from his brother, Frack. Frack originally purchased the stock for $2,000 and it’s worth $10,000 at the time of inheritance. The stock subsequently declines in value and Frick sells it for $8,000. Frick has a $2,000 capital loss due to step-up rules, rather than a $6,000 gain that would apply without the step-up.

Gifts before death receive different tax treatment. In the above example, if Frack gifted Frick the stock prior to his death, Frick steps into Frack’s $2,000 basis. Therefore, when Frick sells the stock for $8,000, he has a $6,000 taxable gain.

Annuities and Life Insurance Proceeds

Annuities: Unlike stocks, bonds, or real estate, annuities do not receive a step-up in basis at death. Thus, the beneficiary will pay income taxes on any gains accumulated in the annuity during the decedent’s lifetime. If the annuity was held inside an IRA, the rules for inherited IRAs apply.

Life Insurance: In most cases, life insurance proceeds paid to beneficiaries are not subject to income tax (IRS). However, if the estate is the beneficiary, the proceeds may be included in the taxable estate.

Retirement Account and Taxable Distributions

Inherited retirement accounts, such as IRAs or employer sponsored plans (401(k)s, 457(b)s, 403(b)s), are subject to special tax rules. While the value of the account itself is not taxed as income upon inheritance, distributions taken from these accounts are typically taxable as ordinary income to the beneficiary. Required minimum distributions (RMDs) may apply, and beneficiaries must pay taxes on the amount withdrawn.

Generally, an individual inheriting an IRA must fully distribute the account within 10 years, commonly referred to as the 10-year rule. The 10-year rule applies to retirement accounts inherited in 2020 or later, with a “lifetime stretch” applying to pre-2020 inherited retirement accounts. Prior to any distributions, an inherited IRA account is set-up with the beneficiaries and the decedent’s name.

Example: Paul was named as the primary beneficiary to his mother’s, Paula’s, Traditional IRA. His mother passed away in 2024. Paul must fully deplete the IRA from 2025 – 2034. Since the assets have not been taxed yet and are growing tax-deferred, all distributions will be taxable as ordinary income. In the event Paula was subject to required minimum distributions (RMDs), Paul will have an RMD each year.

If, instead of a Traditional IRA, Paul inherited Paula’s Roth IRA, everything above is identical, but the Roth IRA retains its tax-free nature and distributions are NOT taxable.

Special note: Paul is permitted to take distributions in 2024, technically adding an 11^th year to the 10-year rule. The caveat being an inherited IRA in Paul’s name needs to be set-up prior to year-end to take advantage of the 11^th year.

There are special rules for spousal beneficiaries.

Example: Pat is named as primary beneficiary on his wife’s IRA. Pat re-titles the IRA to his own name. This account is NOT subject to the 10-year distribution rule.

Trusts can be named as IRA beneficiaries, but special rules apply. In general, the trust must qualify as a “see-through” trust to allow beneficiaries to use the 10-year rule or life expectancy payout options. Otherwise, the account must be fully distributed within five years.

Importance of Naming Beneficiaries

Many financial accounts and insurance policies allow owners to name beneficiaries who will receive the asset directly upon the owner’s death. These transfer mechanisms override instructions in a will or trust and do not require probate court approval. When you properly designate beneficiaries, the institution holding the asset, such as a bank, brokerage firm, or insurance company, will release the asset to the named beneficiary after receiving proof of death.

Naming beneficiaries is a straightforward and powerful way to ensure certain assets are transferred promptly, privately, and efficiently after one’s death. By taking the time to review your assets, thoughtfully select recipients, and coordinate with your broader estate plan, you can spare your loved ones much of the burden of probate and safeguard your legacy.

There is nuance to each situation and consulting a professional may be prudent. The Flagstaff financial advisors at Babb are here to help you build a smart, proactive plan.

The material is for informational purposes only and should not be considered investment advice. The opinions expressed herein are subject to change without notice.