Although it’s never pleasant to lose your nearest and dearest, if they have been kind enough to appoint you as the beneficiary of one or more of their bank accounts in their will, at least that relieves some financial pressure in this trying time.
However, now that you’re the owner of said bank accounts, you may have a few questions about how such an inheritance works.
For instance, can you expect your tax bill to shoot through the roof once your name is on the flush account?
Well, today, this is exactly what we’ll be discussing. Read on and all will be revealed.
Are Inherited Bank Accounts Taxed?
I see no merit in burying the lead here, so let’s dive right into the question of the hour!
Can you expect to be hit with hefty taxation if you come into money via an inherited bank account?
I’m sure you’ll be over the moon to hear that, no, you should not be taxed a dime on any of your inherited assets.
It doesn’t matter if the asset is cash funneled directly into your account, a piece of property, or indeed a bank account where a sum of money already resides… but why is this?
Why Isn’t Inheritance Taxed?
Currently, there are no federal tax laws that apply to inheritance, excluding perhaps possible estate taxes, that could, in certain circumstances, be considered a form of inheritance tax.
But the taxman isn’t just doing you a solid here; there’s a concrete reason why inheritance isn’t usually taxed.
The thing about old money is, well… it’s old.
It stands to reason that the funds you’ll be inheriting have already been subject to tax under the previous ownership.
In this instance, tax isn’t applied per person, but rather, per dollar, and as it’s the very same dollars passing over to you, no taxation occurs.
Having said that, there are a few things to bear in mind, as well as a few exceptions.
Inheritance & Interest
Okay, so you’ve inherited a bank account with a tidy little nest egg accumulating — nice!
But it’s this last word, “accumulating”, that you may want to pay closer attention to.
As I’m sure you’re aware, money accrues interest when sitting idle in accounts, a sort of reward for using and staying loyal to the banking services in question.
Now, once the bank account is in your name, although you won’t have had to pay tax on existing funds, any interest that tallies up after the point of death is technically new income, and not inheritance.
This means that you will indeed have to pay income tax on the interest moving forward, but hey… it’s a pretty nice problem to have.
The same rules apply if there’s some sort of delay in the transference of ownership.
In other words, after the point of death, the interest will need to be taxed, whether your name is on the account or not.
Exceptions To The No Tax Inheritance Standard
Now let’s take a look at some of the scenarios in which you can expect to pay taxes on an inherited bank account or the funds within an existing account.
Pre Tax Savings Accounts — IRAs/401 (K) Nest Eggs
To glean why taxation applies in a pre tax context, it’s important to understand what a pre tax (or deferred-tax) savings account is.
A pre tax savings account is simply a location for pre tax dollars to sit, meaning the money inside is yet to be taxed.
That’s not to say it will never be taxed; taxation has just been deferred.
This saves the original owner a lot of tax dollars over the course of their working life.
But if taxation has just been put on hold, when does it occur?
The funds in a pre tax account are typically taxed once they are withdrawn, which will usually be when the owner is nearing 60 years of age.
So, if, sadly, the original owner of the pre tax account never gets a chance to withdraw the funds, and instead, you inherit the account, when you withdraw the money, you will have to foot the bill for the tax.
Thankfully, there are a couple of workarounds you can use to take the sting out of this sudden tax hike. You could…
- Insert the money directly into your own pre tax retirement account, thereby deferring taxation until you reach retirement age.
- Convert the account into an inherited IRA account that allows you to withdraw the money over a longer period (10 years), so you don’t have to pay the tax all at once.
What About Roth 401 (K) Plans?
Roth 401 (k)s differ from traditional plans in one fundamental way, they are not pre tax retirement accounts.
This means, as you might have guessed, the money placed in these accounts has already been taxed.
In light of this, no taxation will occur when the inheritor withdraws Roth funds, as the previous owner covered the costs years ago.
There are, however, a few stipulations to familiarize yourself with here.
- The Roth account must have been created and contributed to at least 5 years prior to inheritance.
- The funds must have been contributed by the original owner of the account.
Otherwise, you may well be stuck with added tax.
State Inheritance Tax
We’ve established that there are no federal inheritance taxes, but, unfortunately, if you live in Kentucky, Maryland, Iowa, Nebraska, Pennsylvania, or New Jersey, you may well be hit with some regional inheritance tax laws.
The rate of taxation depends on the state and the closeness of your relationship to the deceased.
Spouses, for example, will likely pay nothing in taxes on funds within inherited bank accounts.
The more distantly related you are, the more you stand to pay.
In summation, nine times out of ten, you won’t have to worry about paying tax on the current funds in an inherited bank account, but as soon as it starts generating interest, you will be taxed on the excess.
One last thing to note is if you inherit a bank account as part of an entire estate, and said estate is valued at more than $12.06 million, federal estate tax will apply.
But, being that most of us could only dream of such fortunes, it’s unlikely this will apply to you, and if it does, you’re more than equipped to cover the costs.