In the eyes of the Internal Revenue Service, most inherited money isn't income. If your parents leave you, say, $50,000 and a Ferrari, you don't owe Uncle Sam a penny. Some types of inheritance are taxable, though. On top of that, states and the federal government don't play by identical rules. In some states, your entire inheritance may be taxable.
As of publication, only a half-dozen states impose inheritance tax. If you live in one of them, or if the deceased lived there before she died, you may have to pay. The tax is based on the fair market value of whatever you inherit, but many heirs get an exemption based on their relationship to the deceased. If you inherit from your spouse, there's no tax; if you inherit from your parents, you owe nothing or next to nothing. Friends and more distant relatives pay a higher tax rate.
If you inherit a traditional IRA or a 401(k), you'll probably owe federal tax once you start taking out the money. Usually, you start mandatory minimum withdrawals within a year of the owner's death. You report your withdrawals as income, calculate your tax rate and pay the IRS accordingly. The same applies at the state level. If you inherit a Roth IRA, you're in luck. Withdrawals are still mandatory, but they're tax-free.
The federal government doesn't tax inherited assets such as houses, cars or Van Gogh paintings. If you sell the asset, you pay tax on the capital gains, the difference between the value when the owner died and what you sell it for. If you inherit a $250,000 house and sell it a week later for $250,000, there's no tax due. If you earn income some other way -- an inherited rental house, say -- that income's taxable. You may also owe property tax on inherited real estate.
A trust is a popular tool for passing on an inheritance outside of probate. It's also useful if the grantor -- the trust-maker -- wants to protect the finances of an heir who's irresponsible or mentally handicapped. Instead of handing out the assets after the grantor's death, the trust continues to manage them and distribute the income to the beneficiary. The income is taxable, just as if you'd earned it yourself. Rent from a trust property is taxed as ordinary income.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.