Tax Implications on the Inheritance of Government Bonds

An inheritance can increase your tax bill.

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An inheritance can trigger a number of taxes. If you are the beneficiary of government bonds, you’ll potentially have to contend with estate, inheritance and income taxes. Your tax bill depends on the size of the inheritance, the size of the deceased’s estate, the state in which you live and what you do with the bonds.

Estate Tax

Before you can receive your bonds, the federal government must first determine if it is due any estate tax. The deceased’s estate is the value of the all the property left behind. An estate passed to a surviving spouse doesn't have to pay estate tax. As of 2013, a federal exemption protects the first $5.25 million of the deceased’s estate from tax. The remainder faces at a top rate of 39.6 percent.A surviving spouse's estate exemption upon her death is supplemented by the unused exemption of the first spouse to die. The estate executor pays the tax on the amount in excess of the exemption. This might require the executor to sell a portion of the estate’s assets, including some of the bonds bequeathed to you, to pay the estate tax. States can also tack on their own estate taxes.

Inheritance Tax

Once the executor has paid any estate tax, you can inherit your bonds, but your state might slap on an inheritance tax. Executors pay estate tax, but beneficiaries pay inheritance tax. As of publication, seven states impose inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee. Even if your bond escapes estate tax, you might need to sell a portion of your inheritance to pay the state inheritance tax.

Capital Gains Tax

Your inherited bonds receive a “step-up” in cost basis to their fair market value as of the day of the deceased’s death. The original cost basis is the amount the deceased paid for the bonds. Your cost basis is the stepped-up value. The step-up cuts your capital gains tax when the inherited assets have gained value, because you don’t have to pay taxes on any gains that occurred before the deceased’s death. If you sell the bonds immediately, your capital gains tax should be minimal. All the bonds qualify for long-term capital gains rates, no matter how quickly you sell them.

Interest Income

If you decide to hang onto the bonds, you’ll soon be receiving interest payments that you must include in your taxable income. The tax on the interest is your marginal rate -- the tax on the “last dollar” of annual income. Treasury bonds are free of state taxes, but certain other government bonds don’t receive this exemption. Government bonds typically pay interest twice a year. If you receive a large bond inheritance and therefore large interest payments, you might need to pay estimated tax to avoid penalties for under-withholding. Use Form 1040-ES for this purpose.