Over the next few decades, Millennials and Generation X are set to inherit a staggering $68 trillion as Baby Boomers pass down their wealth. While this sounds like an enormous financial opportunity, inheriting assets can also come with unexpected tax complications. Many people mistakenly assume that receiving a windfall is straightforward, only to be hit with confusing tax rules and unexpected liabilities. Without a clear understanding of how different assets are taxed, you might end up losing more to taxes than you should.

If you’re part of the next generation poised to benefit from this wealth transfer, it’s essential to understand how to manage and protect your inheritance. Let’s take a closer look at how various inherited assets are taxed, the common mistakes to avoid, and strategies to ensure you get the most value from your inheritance.

The Basics of Inheriting Assets

When it comes to inheriting assets, not all property is treated the same from a tax perspective. Different types of assets can come with very different tax rules, and knowing the distinctions can save you a significant amount of money in the long run.

Overview of Inherited Asset Types:

There are several main types of assets you might inherit, each with its own set of tax considerations:

• Cash and Bank Accounts:
  Inheriting cash is the simplest form of inheritance. There’s typically no immediate tax burden on the cash itself, but if the estate value exceeds the federal estate tax exemption ($12.92 million in 2023), estate taxes might come into play. However, some states impose their own inheritance or estate taxes, so understanding local tax laws is crucial.

• Stocks, Bonds, and Other Investments:
  When you inherit stocks, mutual funds, or other investments, you benefit from a concept known as the step-up in basis. This means that the cost basis of the asset is adjusted to its value on the date of the original owner’s death. For example, if your parent bought a stock at $10 per share, and it’s worth $100 when you inherit it, your new cost basis is $100. This step-up in basis can significantly reduce your capital gains taxes if you sell the asset shortly after inheriting it.

• Real Estate:
  Inherited real estate, such as a family home or vacation property, also benefits from the step-up in basis. However, things get more complicated if you decide to keep the property as a rental, sell it, or co-own it with other family members. The step-up can help reduce capital gains taxes if the property is sold, but ongoing property taxes and potential state-specific inheritance taxes can add complexity.

• Retirement Accounts (IRAs, 401(k)s):
  Inheriting a retirement account comes with a unique set of rules. With traditional IRAs and 401(k)s, you’ll have to pay income tax on withdrawals, just as the original owner would have. The SECURE Act of 2019 changed how these accounts must be distributed—non-spouse beneficiaries typically have 10 years to empty the account, creating potential tax planning challenges.

• Business and Estate Interests:
  If you inherit part or all of a business, determining the fair market value and navigating tax rules can be complex. There may be estate taxes, business valuation concerns, and potential income tax implications if the business generates ongoing revenue. It’s crucial to work with a professional to accurately assess and plan for these unique circumstances.

Step-Up in Basis Explained:

One of the most significant tax benefits for inherited assets is the step-up in basis rule. As noted, this adjustment allows heirs to reset the cost basis of an inherited asset to its fair market value on the date of the owner’s death. This rule can minimize the capital gains tax you’ll owe if you decide to sell the inherited property, stocks, or other investments.

For example, if you inherit a property worth $500,000 that was originally purchased for $200,000, your new cost basis becomes $500,000. If you sell the property for $510,000, you’ll only owe capital gains tax on the $10,000 gain, instead of $310,000.

However, the step-up in basis could be at risk of modification or elimination as part of future tax reforms, making it even more critical to stay informed and plan proactively.

Understanding how each type of asset is taxed—and leveraging benefits like the step-up in basis—can help you make informed decisions, preserve the value of your inheritance, and avoid costly mistakes.

How Different Assets are Taxed

Understanding the tax treatment for different types of inherited assets is crucial for making the most of your windfall. Each asset type—whether it’s stocks, real estate, or a retirement account—comes with unique rules that determine how much of your inheritance you get to keep and how much goes to the IRS.

Inherited Cash and Bank Accounts:

If you receive a cash inheritance, you generally won’t have to pay taxes on it. This is the simplest type of inheritance because there are typically no federal income taxes on the cash itself. However, the estate might be subject to estate taxes if the total value exceeds federal or state exemption limits. State-specific inheritance taxes could also apply, so it’s important to check local laws to see if there are any tax implications.

Inherited Stocks and Investments:

Stocks and other investments benefit from the step-up in basis, meaning you won’t pay taxes on the appreciation that occurred during the original owner’s lifetime. For example, if your parent bought a stock at $10 per share and it’s worth $100 when you inherit it, your cost basis is now $100 per share. If you sell the stock at $110 per share, you’ll only pay capital gains tax on the $10 gain, not the full $100. However, if the estate is large enough to trigger estate taxes, this can impact the overall value of the inherited investments.

Inherited Real Estate:

Like stocks, real estate also benefits from the step-up in basis. This means the taxable value is adjusted to the property’s fair market value on the date of inheritance. If you decide to sell the property soon after inheriting it, there may be little to no capital gains tax due. However, if you hold onto it and it appreciates significantly, you’ll owe taxes on the gain from the stepped-up basis to the sale price. If you choose to rent out the property, any rental income will also be taxable.

Inherited Retirement Accounts (IRAs, 401(k)s):

Retirement accounts have their own set of rules and do not receive a step-up in basis. Traditional IRAs, 401(k)s, and other tax-deferred accounts are treated as ordinary income when you withdraw funds. Under the SECURE Act of 2019, non-spouse beneficiaries are now required to withdraw all the funds from these accounts within 10 years of the original owner’s death. This means higher income taxes in a shorter period, potentially pushing you into a higher tax bracket.

If you’re inheriting a Roth IRA, on the other hand, withdrawals are tax-free, but the 10-year rule still applies. You won’t be taxed on distributions, but all funds must be withdrawn within 10 years unless you’re a surviving spouse.

Business and Estate Interests:

Inheriting a business or estate interest is one of the most complex types of inheritances. The fair market value of the business is typically included in the estate’s taxable value, which can trigger estate taxes if it’s large enough. If you plan to keep the business, ongoing income and dividends may also be taxable. For some heirs, setting up trusts or other estate planning strategies can help manage these tax burdens, but it requires careful planning.

Knowing the specific tax rules for each type of asset is the first step in developing a strategy that minimizes taxes and maximizes the long-term value of your inheritance. In the next section, we’ll cover some of the most common tax traps that catch heirs by surprise and how you can avoid them.

Common Tax Traps to Avoid

Handling inherited assets without a clear tax strategy can lead to costly mistakes. These tax traps are easy to overlook but can significantly reduce the value of your inheritance. Let’s look at the most common pitfalls and how to avoid them.

1. Not Understanding the Step-Up in Basis

Misreporting the cost basis is one of the biggest mistakes heirs make, often resulting in paying more in capital gains taxes than necessary. For example, if you don’t apply the step-up in basis when selling inherited stocks or real estate, you could be taxed on gains that technically never existed. Always confirm the new basis value before selling any inherited asset.

Avoidance Strategy : Work with a financial planner or tax advisor to document the fair market value at the time of inheritance, and verify this value before filing your tax return.

2. Mismanaging Inherited Retirement Accounts

Retirement accounts like Traditional IRAs and 401(k)s have their own rules. Under the SECURE Act, most non-spouse beneficiaries must withdraw all funds within 10 years. Taking large distributions in a single year can trigger high tax rates and eat away at the inherited value. Additionally, failing to meet RMD requirements can lead to steep penalties.

Avoidance Strategy : Create a withdrawal plan that strategically spreads out distributions over 10 years to avoid jumping into a higher tax bracket. Consider whether Roth conversions before inheritance could ease the tax burden.

3. Overlooking State Inheritance Taxes

While there is no federal inheritance tax, several states still impose their own. You might assume that because the estate is under the federal estate tax exemption limit, you’re in the clear—only to find out that state-level taxes still apply.

Avoidance Strategy: Check state-specific inheritance tax rules, especially if the deceased lived in a different state than you. A financial professional can help assess whether any state taxes are due.

4. Incorrectly Handling Inherited Real Estate

Selling inherited real estate without understanding the implications can lead to unwanted tax consequences. If you sell a family home without properly applying the step-up in basis, you could face a much larger capital gains tax bill. Additionally, converting a property into a rental can complicate your tax situation further.

Avoidance Strategy : Before selling or converting inherited real estate, consult a tax professional to ensure you’re calculating gains correctly and taking advantage of any exemptions.

5. Ignoring the Impact on Estate Taxes

Even if you inherit assets below the federal estate tax exemption, future tax law changes could affect how these assets are taxed if they appreciate significantly. Moreover, if you’re considering gifting inherited assets, you could unintentionally trigger gift taxes.

Avoidance Strategy : Build an estate plan that accounts for potential appreciation and considers gifting strategies that minimize future tax liabilities.

Strategies for Minimizing Tax Liability

Understanding the tax implications of inherited assets is only the first step—creating a strategic plan to minimize taxes is where you can really protect your wealth. Here are some key strategies to consider:

1. Establishing an Inherited Asset Plan Before the Wealth Transfer

If you anticipate receiving an inheritance, it’s crucial to plan ahead. Discuss the estate’s structure with your parents or relatives and work with a financial advisor to identify potential tax liabilities. By establishing a plan before the transfer occurs, you can incorporate strategies such as gifting and charitable giving to reduce overall tax burdens.

Example Strategy : Suppose you know you’ll inherit a large taxable estate. Gifting some assets early can reduce the estate’s value and minimize future estate taxes. This approach, however, must align with the lifetime gift tax exemption rules to avoid triggering gift taxes.

2. Using Trusts to Shield Assets and Reduce Tax Burden

Trusts are a powerful tool for managing and distributing assets in a tax-efficient manner. Depending on your needs, a revocable or irrevocable trust can help keep assets out of the taxable estate, reduce income taxes, and ensure that your inheritance is distributed according to your wishes.

Types of Trusts to Consider:

• Charitable Remainder Trusts (CRTs) : These trusts provide an income stream to heirs and leave the remainder to a charitable organization, reducing both estate and income taxes.

• Dynasty Trusts : Help preserve wealth across multiple generations while minimizing estate and generation-skipping transfer taxes.

3. Leveraging the Lifetime Gift Tax Exemption Strategically

If you’re concerned about future tax liability, using the lifetime gift tax exemption can be a smart way to transfer wealth incrementally. Currently, the exemption is $13.61 million per person (as of 2024). By gifting up to this amount during your lifetime, you can reduce the size of the estate, thereby decreasing the tax burden for your heirs.

Example : Let’s say you want to transfer a business to your children. By gifting shares incrementally, you can use the annual exclusion ($18,000 per person) alongside the lifetime exemption to reduce gift and estate taxes over time.

4. Roth Conversions for Inherited Retirement Accounts

If you expect to inherit a traditional IRA or 401(k), converting it to a Roth IRA while the original owner is still alive can save thousands in future taxes. Although you’ll pay taxes upfront on the converted amount, all future growth and withdrawals will be tax-free, easing the burden for your heirs.

When to Use : This strategy is particularly beneficial if the original account holder is in a lower tax bracket now and expects heirs to be in a higher tax bracket when they inherit the account.

5. Implementing Charitable Giving Strategies

Charitable giving isn’t just about supporting a cause—it’s also a smart tax strategy . If you plan to leave a substantial estate, consider setting up a Charitable Lead Trust (CLT) or Charitable Remainder Trust (CRT). This not only reduces the taxable value of your estate but also provides income or tax benefits during your lifetime.

Qualified Charitable Distributions (QCDs) can also be used to reduce RMDs from inherited IRAs, lowering your taxable income while supporting a charitable cause.

Planning Ahead for the Boomer Wealth Transfer

With Baby Boomers set to pass down an estimated $68 trillion over the coming decades, Millennials and Gen Xers must be proactive about tax planning to protect their share of this wealth transfer. Here’s how you can plan ahead to maximize the value of your inheritance.

1. Be Prepared for Potential Tax Law Changes

The tax landscape is always shifting, and future changes could affect the taxation of inherited assets. One major concern is the potential modification or elimination of the step-up in basis, which could significantly increase capital gains taxes on appreciated assets. Additionally, the current estate tax exemption ($13.61 million in 2024) could be reduced, making more estates subject to taxes.

Strategy: Stay informed and work closely with a financial planner to adapt your strategy based on legislative changes. Building flexibility into your plan can help you pivot quickly if new laws impact estate or inheritance taxes.

2. Start the Family Conversation Early

Discussing money and inheritance can be uncomfortable, but it’s critical to understand the intentions and structure of the estate before wealth is transferred. By having open discussions now, you can ensure that everyone is on the same page and that tax strategies are implemented early to reduce potential issues later.

Tip : Encourage Boomer parents to update their estate plans regularly, as their circumstances and tax laws evolve. Establishing clear lines of communication can also help reduce the risk of family disputes.

3. Document Intentions to Minimize Disputes

One of the most overlooked aspects of estate planning is properly documenting the original owner’s intentions. A lack of documentation can lead to confusion, disputes, and even higher legal costs. Make sure that all assets, especially business and real estate interests, are clearly defined and that beneficiaries know their roles.

Example : If a parent intends to leave a rental property to one child and stocks to another, ensure this is documented in the estate plan to avoid potential misunderstandings that could lead to contested estates or unintended tax consequences.

4. Consider Using Life Insurance for Liquidity

When large, illiquid assets (like a family business or real estate) are part of an estate, heirs may struggle to pay estate taxes without selling part of the inheritance. Life insurance can be a strategic solution, providing liquidity to cover estate taxes, legal fees, and other expenses without having to sell the inherited assets.

Strategy: Use life insurance policies to ensure that heirs can cover these costs without needing to sell properties or business interests prematurely. This approach can also help equalize inheritances if certain heirs are not involved in the business or wish to sell the real estate.

5. Leverage Gifting Before Inheritance

Encourage Boomer parents to consider gifting strategies before passing away. Using the lifetime gift tax exemption strategically can reduce the size of the taxable estate and minimize the tax impact on heirs.

Tip: Parents can take advantage of the annual exclusion ($18,000 per person in 2024) to gift assets tax-free each year, reducing their taxable estate over time. For larger estates, structured gifting plans using trusts can preserve wealth for future generations while avoiding large tax bills.

How Will You Handle It?

Handling the taxation of inherited assets can be complex, especially as Millennials and Gen Xers prepare for the largest wealth transfer in history. Whether it’s real estate, stocks, or retirement accounts, each type of asset has unique tax considerations that can either enhance or diminish the value of your inheritance. By understanding the rules, avoiding common pitfalls, and implementing strategies like trusts, Roth conversions, and proactive planning, you can preserve more of your wealth.

Ready to protect your financial future? Consult a financial advisor today to build a tax-efficient strategy that maximizes the value of your inheritance and secures your long-term financial goals. Don’t wait until the tax bill arrives—start planning now to ensure your family’s wealth endures.