For many retirees, leaving money to heirs is just as important as having enough to live comfortably. After a lifetime of saving, it’s natural to want your children or grandchildren to benefit from what you’ve built. That may leave you wondering… Will my heirs owe taxes on the money I leave them?
The answer depends on what kind of assets you leave behind, and the account you hold them in. Some inheritances pass tax-free, while others can create a significant tax bill for your heirs. Let’s look at how different types of assets are taxed, and what you can do to make things easier for your loved ones.
Estate Taxes vs. Inheritance Taxes
First, let’s clear up some confusion. There is no such thing as a federal inheritance tax. There is an estate tax, but only very large estates are subject to estate tax. For 2025, the federal exemption is over $13 million per person, which means most retirees don’t have to worry about federal estate tax.
Some states have their own estate or inheritance taxes, though they usually kick in at much lower levels. Texas, for example, has neither. But if you live in (or your heirs live in) states like Maryland, New Jersey, or Oregon, these taxes could apply.
For most retirees, though, the bigger issue isn’t estate tax. It’s how specific accounts and assets are taxed when heirs withdraw or sell them.
Inherited IRAs and the SECURE Act
Traditional IRAs and 401(k)s are often the most confusing for heirs. Since these accounts are tax-deferred, taxes must be paid when the money comes out. That’s true whether you withdraw the money or your heirs do. Under the SECURE Act, most non-spouse beneficiaries who inherit an IRA now have to withdraw all of the funds within 10 years.
That means your children could be forced to take large taxable withdrawals, possibly during their peak earning years. The extra income could push them into higher tax brackets and reduce the value of the inheritance.
By contrast, spouses who inherit IRAs have more flexibility. They can roll the account into their own IRA and take distributions over their lifetime.
Inherited Roth IRAs
Roth IRAs work differently. Withdrawals are generally tax-free for heirs, as long as the account has met the five-year rule. The SECURE Act still requires most non-spouse beneficiaries to empty the account within 10 years, but the distributions themselves are not taxable.
This makes Roth accounts an excellent tool for estate planning. By converting traditional IRA money to Roth during your lifetime, you can pay the taxes yourself and leave your heirs a tax-free gift. It may be possible to spread these conversions out over a longer period of time to reduce the total taxes paid as well.
Taxable Accounts and the Step-Up in Basis
Brokerage accounts assets like real estate have another set of rules. When you pass away, most assets in taxable accounts receive a step-up in basis.
That means the cost basis is “reset” to the value on the date of your death. If your heirs sell the assets right away, they typically owe no capital gains tax. If they hold them and the assets continue to grow, only the growth after the date of death is taxable.
For example, if you bought a stock years ago for $20,000 and it’s worth $100,000 when you pass, your heirs’ basis becomes $100,000. If they sell it for $100,000, no tax is due. Without the step-up, they’d owe tax on an $80,000 gain.
This rule also applies to land or other real estate that you pass to heirs.
Life Insurance
Life insurance proceeds are generally tax-free to beneficiaries. Your heirs receive the death benefit without paying income tax.
For most retirees, life insurance is one of the simplest ways to pass money to heirs without tax complications.
Strategies to Reduce Taxes for Heirs
If one of your goals is to minimize taxes for your heirs, there are several strategies to consider:
- Roth conversions: Paying taxes during your lifetime on IRA balances can leave heirs with tax-free withdrawals. You can also spread the conversions out over longer than the 10 years your heirs will have to withdraw the money, meaning you may be able to lower the average tax rate.
- Strategic withdrawals: Taking money from traditional accounts gradually can prevent large balances from being forced out under the 10-year rule.
- Gifting during your lifetime: You can give up to $18,000 per year (per person, as of 2025) without gift tax. Larger amounts may be applied against your lifetime exemption.
- Trusts and estate planning: In some cases, using trusts can help manage how assets are distributed and potentially provide tax benefits.
- Life insurance: Provides a clean, tax-free way to pass wealth.
An Example
Let’s imagine two retirees, both leaving $500,000 in a traditional IRA to their children.
- Retiree A: Does no planning. The children inherit the IRA and must withdraw the money within 10 years, adding $50,000 of taxable income per year on top of their salaries. This pushes them into higher tax brackets and reduces the value of the inheritance.
- Retiree B: Does partial Roth conversions during retirement, paying the taxes out of non-retirement funds. The children inherit a mix of Roth and taxable assets. The Roth withdrawals are tax-free, and the taxable accounts get a step-up in basis. The children keep significantly more of the inheritance.
Plan Ahead for Inheritance Taxes
Whether your heirs owe taxes on what you leave depends on the type of accounts and assets you hold. Traditional retirement accounts can create tax challenges for your children, while Roth accounts, taxable accounts with step-up in basis, and life insurance are often more tax-friendly.
The key is to align your estate and tax planning with your overall goals. If leaving money to heirs is important to you, there are strategies to reduce the tax burden and maximize what your heirs receive. With thoughtful planning, you can minimize the tax implications of leaving money to heirs.
If you’d like to talk to talk abut making a plan to reduce your taxes and make sure you are able to retire comfortably, email me at [email protected] or call 903-471-0624 and we will get started
