Impact of Inheritance on Retirement Planning

As you approach retirement, it's essential to consider the impact taxes can have on your retirement income, as well as any potential inheritance you may receive. Inheritance, whether in the form of cash, property, or investments, can have tax implications that you need to consider.

Social Security Taxes

One of the most significant sources of retirement income for many people is Social Security. However, if you have other sources of income, including an inheritance, you may end up paying taxes on your Social Security benefits. The IRS uses a formula to determine how much of your Social Security benefits are subject to taxes. The formula takes into account your other sources of income, including retirement accounts, pensions, investments, and any inheritance. If your combined income is above a certain threshold, you may have to pay taxes on up to 85% of your Social Security benefits.

Retirement Account Taxes

If you receive an inheritance, it's important to consider the impact it may have on your retirement account taxes. Inherited retirement accounts, such as an IRA or 401K, can be subject to income taxes when they're withdrawn. The amount of tax you owe will depend on your income tax bracket, as well as the size of the withdrawals. Under the old rules, beneficiaries of inherited 401(k)s were able to stretch out distributions over their lifetime, allowing them to take smaller distributions and reduce their tax liability. However under the new rules implemented in 2019, most non-spouse beneficiaries are required to withdraw the entire balance of the inherited 401(k) within 10 years of the account owner's death. Keep in mind that people receiving inheritance generally do so in their highest earning years. If you inherit a Roth IRA, you will not have to pay taxes on withdrawals as long as the account has been open for at least five years.

Capital Gains Taxes

When it comes to inheritance, you may also need to consider capital gains taxes on inherited assets. Capital gains taxes are taxes on the profit you make when you sell an investment for more than it's original purchase price. If you inherit investments outside of retirement accounts, you may have to pay capital gains taxes when you sell them. However, there is a strategy that can help you save on these taxes: step-up valuation.

Step-up valuation is a tax benefit that allows you to adjust the cost basis of an inherited asset to it's current market value at the time of inheritance. This means that if the asset has appreciated in value since the original purchase, you will only owe capital gains taxes on any increase in value that occurs after you inherit the asset. This can significantly reduce your tax liability, as the appreciation in value that occurred before you inherited the asset is effectively wiped out for tax purposes.

For example, let's say your grandmother purchased stock for $10,000 and it is now worth $50,000 when she passes away and leaves it to you. If you were to sell the stock immediately after inheriting it for $50,000, you would owe capital gains taxes on the $40,000 increase in value since the original purchase. However, if you choose to hold onto the stock and sell it later for $60,000, you will only owe capital gains taxes on the $10,000 increase in value that occurred after you inherited the asset.

Typically, to qualify for the step-up valuation, you must hold the inherited asset for at least six months after the date of inheritance. This means that if you sell the asset before the six-month mark, you will not be able to take advantage of the step-up in basis and may be subject to capital gains taxes on the original purchase price.

Estate Taxes

In addition to income and capital gains taxes, you may also need to consider estate taxes if you receive a significant inheritance. Estate taxes are levied on the total value of the estate, including property, investments, and cash. The federal estate tax exemption for 2023 is $12.92 million per individual, which means that if the total value of the estate you inherit is less than that, you won't owe any federal estate taxes. However, some states also have their own estate or inheritance taxes with a much lower threshold, so it'a important to check the laws in your state.

In conclusion, inheritance can have significant tax implications during your retirement years. It's important to work with a financial advisor or tax professional to develop a comprehensive retirement plan that take taxes and potential inheritance into account. With careful planning and the right strategies, you can minimize your tax bill and maximize you retirement savings and the impact.