Tax implications and 3 essential steps to manage an inheritance
Receiving an inheritance can be an emotional experience, and if it includes a brokerage account, you’re probably asking questions like: what do I need to do and do I owe any taxes? We’ll walk through essential steps to take so you can honor the legacy left to you while making informed decisions about your financial future.
Step 1: Understand the Type of Account
The first step is to determine the type of brokerage account you’ve inherited. Generally, these accounts fall into two categories: Qualified (tax-deferred) or Non-Qualified (after-tax).
Qualified Accounts (tax-deferred)
Qualified accounts are typically funded with pre-tax dollars and enjoy special tax treatment. This means you don’t pay taxes on the contributions and earnings until you start withdrawing the money. Some common examples of qualified accounts include 401(k)s, 403(b)s, and traditional Individual Retirement Accounts (IRAs).
If you’ve inherited one of these accounts, you’re entitled to the account’s value. But because the taxes haven’t been paid on these accounts yet, it’s up to the beneficiary to handle them when the funds are distributed.
The rules around inherited IRAs can be a bit complicated and depend on several factors, like your relationship to the original owner, the age difference between you and them, and whether they had started their Required Minimum Distributions (RMDs). There are other considerations to consider, too, that a financial planner can help guide you through.
Non-Qualified Accounts (after-tax)
These accounts are typically funded with after-tax dollars and don’t get the same tax perks as qualified accounts. Common examples of non-qualified accounts include Taxable Investment Accounts (like those used for stocks, bonds, mutual funds, or ETFs), Savings Accounts, and Non-Qualified Annuities.
An important aspect about non-qualified accounts is a concept known as ‘cost basis’. Cost basis is the amount that was initially invested that taxes were already paid on. If an investment was purchased for $10,000 and then sold later for $12,000, the seller would pay tax on the capital gain of $2,000. The original $10,000 purchase amount isn’t taxed again.
When someone dies, the cost basis of a non-qualified brokerage account is usually adjusted to the fair market value of the asset on the date of their death. This is called a ‘step-up in basis’ and it applies to most brokerage accounts (with the exception of non-qualified annuities). The step-up in basis can significantly reduce the capital gains tax owed by the beneficiary when they sell the asset.
Step 2: Notify the Brokerage Firm
- The executor will need to notify the brokerage firm about the account holder’s passing. This starts the transfer process. Each brokerage company has slightly different procedures, but they’ll likely ask for several of the following documents: a death certificate, which you can order from your state’s Vital Records website or State Department of Health.
- A court letter of appointment naming the executor, which should be current and have original court seal.
- Trust agreement showing your trustee certification if the account is held in a trust.
- A letter of authorization for joint accounts, signed by the surviving tenant, if the assets are going into an account other than their own.
- Stock power, which is the power of attorney to allow for transferring stock ownership.
- Affidavit of domicile, which verifies the deceased’s home address.
Step 3: Work with a Financial Planner
Inheriting a brokerage account can significantly impact your financial situation, and you’ll want to consult with a financial planner to incorporate the asset(s) into your own financial plans. A planner will help you address tax implications to help you understand if you are paying income taxes or capital gains taxes and manage these in the most effective way.
A financial planner will also help you evaluate the investments and review your portfolio to identify its strengths and weaknesses, rebalance the assets to best fit your needs, and help you in evaluating whether to retain, sell, or reinvest the assets based on your goals.
At Johnson Bixby, our team walks alongside clients to help them navigate inheritance and make decisions based on their individual situation, goals – and dreams. Please reach out if you are expecting or have received an inheritance. We’re happy to help guide the way for you.
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