By Stephen W. Bedikian, Associate Wealth Advisor
Key Takeaways
- Most inheritances aren’t federally taxed, but exceptions exist. Federal estate taxes apply to large estates, and some states impose inheritance or estate taxes.
- Inherited retirement accounts can create major tax burdens. IRAs and 401(k)s are tax-deferred, meaning beneficiaries often owe income taxes on distributions.
- Estate planning strategies can help reduce taxes for heirs. Options like Roth conversions, charitable distributions, and trusts can help preserve more wealth for beneficiaries.
Do you have to pay taxes on an inheritance?
For the most part, any inheritance you receive doesn’t count as income at the federal level. But some states do impose inheritance taxes. And there’s a “hidden” federal inheritance tax – on inherited individual retirement accounts (IRAs) – that most people neglect to plan for. More on that below. Let’s tackle estate taxes first.
How the Federal Estate Tax Works Today
The federal estate tax is paid by a decedent’s estate before assets are distributed to heirs and is imposed on the overall value of the estate. Federal estate taxes have been levied in the U.S. since 1916, but the bar is set quite high right now. Last year Congress passed the One Big Beautiful Bill Act that permanently increased the estate tax exemption amount to $15 million per person – or $30 million per married couple. Many very wealthy Americans no doubt breathed a collective sigh of relief.
But before the vast majority of American households relax, there’s one huge catch to the current tax picture. There’s really no such thing as ‘permanent’ when it comes to the U.S. tax code. An act of Congress made the current exemption amount permanent, but it can be changed at any time in a future session of Congress. When a new President is elected every four years, changes to the tax code are often made to reflect the new administration’s policies. As recently as 2017, the estate exemption amount was about $5.5 million, and back in 2000, it was just $675,000.
The current estate tax rate is 40%, but back in the 1970s, it was 70%! Since the U.S. Federal Debt now stands at about $38.5 trillion and climbing rapidly, higher future tax rates are a distinct possibility.
Which states have inheritance and estate taxes?
Five states do impose inheritance taxes – Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania – and Maryland imposes both an estate and an inheritance tax.
Twelve states impose estate taxes. State estate tax exemption amounts vary considerably. In Washington state, the exemption amount is $3.076 million in 2026 and the estate tax starts at 10% and rises up to 35% for estates over $9 million. The top estate marginal tax rate in Hawaii is 20%; it’s 16% in the District of Columbia and eight other states. Recall that, like income taxes, the state estate tax is levied in addition to the federal estate tax, so a Washington state household could potentially face a combined estate tax rate of 75% (40% Federal + 35% state) on a portion of their estate assets.
All five states that levy an inheritance tax vary the rate by family distance of the heir. For example, in Kentucky, the child of the decedent pays a maximum tax rate of 10% on their inheritance for a value exceeding $500,000, whereas non-family heirs pay a much higher 16% tax rate on values exceeding just $60,000.
Ways to help avoid inheritance tax on inherited IRAs and 401ks
While estate and inheritance taxes are often the subject of extensive estate planning, the biggest inheritance tax is often ignored because it’s not labeled an inheritance tax. It’s the income taxes that IRA and 401k beneficiaries will pay on inherited IRA distributions.
Remember that these tax-deductible retirement account contributions are only tax deferred – not tax free. According to the Investment Company Institute for example, American households held $17 trillion in IRAs at the end of 2024.
Although the rules on Inherited IRA and 401k distributions are somewhat complex, most non-spousal heirs must complete distribution of these funds within 10 years if the decedent passed away on or after January 1st, 2020.
Strategies to Help Reduce Inherited IRA or 401k Tax Liability for Heirs
Imagine that you’ve diligently contributed to a traditional 401k account or IRA throughout your working life and the balance has grown to $2 million. After it’s distributed you have to pay federal and state ordinary income taxes on those withdrawals. When you pass away, as the designated beneficiary, your child will inherit that $2 million IRA and they will have a maximum of just 10 years to fully deplete it. In a high-income-tax state like California, for high-earning heirs, there are scenarios under which close to half of that $2M could go to federal and state coffers.
Once you appreciate the potentially large embedded tax liability in your traditional IRA, you can take steps to potentially reduce it and aim to maximize the after-tax value for your heirs. There are multiple options to consider:
- Roth Conversion: You make the choice to convert some or all of your traditional IRA to a Roth IRA, pay the taxes now and thereby eliminate the tax liability entirely for your heirs. The double benefit of this strategy is that your heir(s) can leave the entire balance of the Roth IRA undistributed until the end of year 10 and take it out all at once. This offers an extra decade of tax-deferred compounding and taking it all out at once won’t push them into a higher tax bracket because Roth distributions are tax free. This option can be particularly compelling if you are in a significantly lower tax bracket than your child.
- Qualified Charitable Distribution. Any distributions made from a traditional IRA and paid directly to a charitable institution are tax-free. Voila, you’ve eliminated the tax liability on the portion of your IRA assets that are donated. For 2026, the maximum QCD is $111,000 per spouse or $222,000 for a married couple. If you have a 401k, once you reach 70 ½ you can roll over funds into an IRA to make a QCD.
- Establish a Testamentary Charitable Remainder Unitrust (T-CRUT). A T-CRUT can be named as the beneficiary of your IRA. The trust will make annual payments to your beneficiaries; at the end of the trust’s life, the remainder is distributed to a charitable organization.
There’s a lot of flexibility in the structure of a T-CRUT, but the remainder amount must be at least 10% of the initial fair market value of trust assets. Non-charitable beneficiaries like your children can receive income payments for up to 20 years – rather than the 10 years required for an inherited IRA. For heirs in high-tax brackets, this can potentially allow them to stay in a lower tax bracket during the distribution period.
Start Now to Help Strengthen Your Estate’s Long-Term Value
It’s important to get started early so strategies can be implemented in the most tax-efficient way. Your Halbert Hargrove advisor can work with you and your estate planning attorney to help optimize the after-tax value of your IRA – as well as your entire future estate – for your heirs.
Explore Halbert Hargrove’s estate planning services.
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