Inheriting investments can be a nice, unexpected windfall, giving you an immediate boost to your net worth. With nonqualified investments you also receive the stocks, bonds or fund shares on a tax-advantaged basis. If you inherited qualified money like an individual retirement account, you would eventually need to pay taxes on the full amount. The opposite is true with nonqualified investments, where the full amount passes to you basically tax free -- at least in the beginning.
Estate Pays First
Before nonqualified inherited investments are turned over to you, the estate will handle the taxes incurred due to the death of the previous owner. Inheritance or estate taxes and taxes on earnings from the investments before they are distributed to you will all be reported and paid by the executor of the estate out of estate assets. If the estate files a tax return, you will want a copy for your records.
Step up in Basis
Inherited nonqualified investments are owned at a "stepped-up basis." Your cost for tax purposes is the value of the investment on the date the previous owner died or a slightly later alternate date chosen by the estate executor. As a result, if the original owner had big gains on an investment when she died, those gains are not taxable to you. Taxes on the gains up to the time of death are forgiven. You are only responsible for taxes on any gains incurred since the death or alternate valuation date. The value of the investments for your cost basis will be listed on the estate tax return.
Selling Inherited Investments
If you sell an inherited investment, the result will be a capital gain or loss based on the selling price and the stepped-up basis on that security. The rule for capital gains is that investments owned for more than one year are long-term gains and taxed at a lower rate. With inherited securities, the gain will be classified as long-term even if you have been the owner for less than the one year cutoff. When you report a sold inheritance on your tax return, put "inherited" in the purchase date column to show the gain qualifies for the long-term capital gains rates. If the investment lost value compared to the cost basis, the loss can be used as a tax write-off.
Dividends and Interest
If the investments you inherited pay dividends or interest, that income will be yours once you officially own the securities. Stock or fund dividends or bond interest will be reported to you on a Form 1099 and included on your tax return. If you inherited municipal bonds, the interest from this type of bond is exempt from federal income tax.
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