It might be hard to believe, but amounts received as a gift or inheritance are, regardless of amount, not subject to income tax. Really.
Now, myriad other taxes imposed on lifetime and testamentary transfers, such as Federal and New Jersey Estate Tax, Federal Gift Tax, New Jersey Inheritance Tax, or Federal Generation Skipping Transfer Tax might have taken a bite out along the way, but the amount that a beneficiary ultimately receives from an estate or trust is not subject to income tax. Again, this is regardless of amount, so many people simply cannot believe it.
The free ride stops, however, for income earned on the amounts to be inherited. Estates and Trusts are taxed for income tax purposes under a regime which can best be described as “follow-the-money.” If any Estate or Trust earns income on assets that it holds, the Estate or Trust pays tax on that income, but if the income is distributed to the beneficiary, the beneficiary pays the tax. Still, the underlying asset is not subject to income tax, only the income generated by that asset. For example, if a trust has $1,000,000 invested and earns $50,000, the trust pays income tax on $50,000 if it keeps the income, but the beneficiary pays the tax if that amount is distributed; however, if $100,000 is distributed to the beneficiary, the $50,000 in income is taxable to the beneficiary and the other $50,000 is classified as a gift or inheritance and therefore not subject to tax.
Note that special rules apply for amounts received from so-called “tax-qualified” assets, such as IRAs, 401(k)’s, tax-deferred annuities or other retirement accounts. Amounts received from those assets, since they have never been subject to income tax, ARE TAXABLE to the beneficiary. Some relief may exist in the form of an income tax deduction available for any Federal Estate Tax also imposed on the tax-qualified asset at the estate level, so beneficiaries should always request a copy of the Federal Estate Tax Return (if required to be filed) in order to determine whether that deduction is available.
Our next post will address a surviving spouse’s so-called “Elective Share” and “Omitted Spouse” rights.