Good question. I bet you’re looking for a yes or no answer though and it’s not quite that easy.
Everybody talks about the “death tax” but for most people, there’s no such thing. Generally, if you inherit money, you do not pay tax on it. There are a couple of states that tax inheritances, but the federal government does not.
But… (You were waiting for the ‘but’ weren’t you?) While you won’t be taxed on the inheritance itself, you can be taxed on the income of a deceased person’s estate. The easiest way to explain this is with an example.
Let’s say your Uncle Bob dies and leaves you $10,000 in his will. Cool. You get $10,000 cash, and that’s it. There’s no inheritance tax. He just left you a dollar amount; nothing to it but cash.
But what if instead of just leaving you cash, your Uncle Bob left you half of his estate? Suppose he leaves half of everything he owns to you and the other half to your sister. Let’s say he has $50,000 cash in the bank.
It might take some time for the estate to settle and for you and your sister to get what’s coming to you. During the time after your uncle’s death and before you settled the estate, the estate (that is, the stuff your uncle used to own) made some money. Interest was paid on the bank account. While you won’t pay tax on the $25,000 cash you get, you will pay tax on the interest that the cash earned while it was part of the estate. It will be “passed through” to you as the beneficiary.
That’s the part that’s really confusing to most people. You read the IRS books that say inherited money isn’t taxable—it isn’t. But the income that money earns while it’s sitting in the estate is.
The taxable income will be reported on a document called a K1. If you’ve never seen one before, it’s a little intimidating. But if you’re doing your own taxes, you just input the numbers from the K1 into the boxes in the software and you’re going to be okay.
So, if the $50,000 in the bank earned $1,000 in interest and you’re supposed to get half of the estate, then you’ll pay tax on $500 (your share of the interest earned) and you’ll get $25,500. (Half of the $50,000 plus half of the interest earned.)
Now, realize that I’ve really simplified this. Usually there’s more than just a bank account. There will be stocks, a house, maybe even a business. But the idea is basically the same: you pay tax on the income that the estate earns, but you don’t pay tax on the value of the actual stuff in the estate. (If we’re looking at estates that are worth over $5 million dollars, referred to as the $5 million estate-tax exemption—that’s another story, but that’s not what I’m talking about today.)