Receiving an inheritance or any form of unexpected financial windfall can be life-changing. However, while you may be focused on the immediate benefits, it’s crucial to understand the tax implications that come along with these financial gains. Tax laws can vary depending on the type of asset, its value, and the state you reside in. To help you make informed decisions, here are the key tax considerations to keep in mind when receiving an inheritance or windfall.

1. Estate Taxes

One of the first tax-related concerns involves estate taxes. Estate taxes are levied on the estate of the deceased before the assets are distributed to the heirs. In the United States, the federal estate tax exemption is quite high (over $12 million as of 2024), meaning that most estates won’t owe federal estate taxes. However, some states have their own estate tax thresholds, which are significantly lower than the federal limit.

If you are inheriting from a large estate, ensure that the executor has paid any applicable estate taxes before you receive your inheritance. While estate taxes are not your responsibility directly, they can reduce the overall value of the estate before distribution.

2. Inheritance Taxes

Unlike estate taxes, inheritance taxes are imposed directly on the individual who receives the inheritance, rather than on the estate itself. Only a handful of states, including Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania, impose an inheritance tax. The rate of inheritance tax can vary based on the relationship between the beneficiary and the deceased. For example, in some states, immediate family members may be exempt from inheritance tax, while distant relatives or unrelated individuals may face higher rates.

If you live in a state with inheritance taxes, it’s important to consult with a tax advisor to understand your liability and to ensure that you’re prepared for any taxes owed.

3. Capital Gains Tax

If you inherit property, stocks, or other assets, capital gains tax may come into play when you decide to sell those assets. The good news is that inherited assets benefit from a “stepped-up” basis. This means that the value of the asset is adjusted to its market value at the time of the deceased’s death, rather than when the deceased originally acquired it.

For example, if you inherit a home worth $500,000 that was originally purchased for $200,000, the “stepped-up” value is $500,000. If you later sell the home for $550,000, you will only owe capital gains tax on the $50,000 profit, rather than the $350,000 difference from the original purchase price.

However, if the asset appreciates significantly after the time of inheritance, the capital gains on the sale could be substantial, so it’s wise to plan accordingly.

4. Income Tax on Retirement Accounts

Inheriting a retirement account, such as an IRA or 401(k), can come with specific tax implications. If the account was a traditional IRA or 401(k), you will generally owe income tax on any distributions you take from the account. The exact tax treatment depends on several factors, including your relationship to the deceased and the type of retirement account.

If you are a spouse, you can typically roll the account into your own retirement account and defer taxes until you begin making withdrawals. For non-spouse beneficiaries, however, there are stricter rules regarding required minimum distributions (RMDs), often requiring the account to be emptied within 10 years of inheritance. It’s essential to understand these rules to avoid unexpected tax penalties.

5. Gift Taxes

In cases where a loved one gives you financial gifts before their death, you might encounter gift tax concerns. The federal government allows individuals to give up to a certain amount tax-free each year (the annual gift tax exclusion is $17,000 per person for 2024). Any gifts exceeding this amount may be subject to gift tax, but it’s worth noting that the donor—not the recipient—is generally responsible for paying the gift tax.

However, large financial gifts given before death may affect the overall value of the estate and the taxes owed during probate. It’s a good idea to discuss potential gift tax implications with a financial advisor if you expect large lifetime gifts.

6. Tax on Legal Settlements

Sometimes windfalls come from legal settlements, such as from a personal injury case or a business-related lawsuit. Depending on the type of settlement, portions of the payout may be subject to taxes. For example, compensatory damages related to physical injury are generally tax-free, while punitive damages or settlements related to emotional distress or lost wages may be taxable.

If you receive a legal settlement, make sure to get clear advice on which portions of the settlement are taxable and which are exempt.

7. Tax Planning with Inheritance Advances

If you’re waiting for an inheritance to go through probate, you may consider taking an inheritance advance to cover immediate financial needs. The good news is that inheritance advances are typically structured as loans, so they are not taxable as income. However, it’s important to plan how you’ll manage your finances once the probate process concludes, ensuring that you can cover the loan repayment while considering any taxes on the inherited assets themselves.

8. Setting Aside Money for Taxes

One of the most critical steps in managing a windfall is setting aside a portion of the funds for any taxes that may arise. This is especially true for large inheritances, property sales, or legal settlements. Consulting a tax advisor early on will give you a clearer picture of your tax liability and help you avoid costly penalties down the road. If you’ve inherited assets that could trigger capital gains or income taxes, be proactive in saving part of your windfall for these future obligations.

Conclusion

While receiving an inheritance or windfall can be a significant financial boost, it’s important to navigate the tax landscape carefully. From estate and inheritance taxes to capital gains and income taxes, the tax implications of a windfall can vary based on the type of asset and the laws of your state. Working with a tax advisor is essential to ensure that you manage your newfound wealth wisely and avoid any surprises come tax season. Proper tax planning will help preserve your wealth and allow you to make the most of your financial windfall.