Inheritance: Insurance Income Or Not?

Inheritance is generally not considered income for federal tax purposes, but it can impact your insurance. While inheritances are not taxable income, any subsequent earnings on inherited assets, such as interest income and dividends, are typically taxable. However, if you are on government assistance programs like Medicaid, receiving an inheritance may impact your eligibility and result in repayment obligations for benefits received during the period of nondisclosure. Additionally, certain types of inherited assets, such as retirement accounts, may trigger specific tax implications.

Inheritances aren't considered income for federal tax purposes

Inheritances are not considered income for federal tax purposes. However, this does not mean that they are entirely tax-free. While the federal government does not impose an inheritance tax, certain types of taxes may apply to an inheritance. These include estate taxes, inheritance taxes, and capital gains taxes.

Estate Taxes

The estate tax is a federal tax imposed on property transferred after the owner's death. The tax is owed by the estate, not the beneficiaries, and is based on the size of the estate. In 2024, the first $13.61 million of an estate is exempt from taxes. The estate tax is progressive, meaning that the larger the estate, the higher the tax rate. Rates range from 18% to 40%.

Inheritance Taxes

Inheritance taxes are imposed on the recipient of an inheritance rather than the estate itself. While there is no federal inheritance tax, a handful of states do impose this tax. These include Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The tax rates vary by state and the relationship between the beneficiary and the deceased.

Capital Gains Taxes

Capital gains taxes are imposed on the sale of assets, including inherited assets. If you sell an inherited asset for more than its value at the time of the original owner's death, you will be subject to capital gains tax on the gain. Federal capital gains are taxed at either 0%, 15%, or 20%, depending on your taxable income for the year.

It is important to note that any income generated from an inheritance, such as interest or dividends, is generally considered taxable income. Additionally, if you inherit assets in a pre-tax account, such as a 401(k) or traditional IRA, withdrawals from these accounts will be considered income and subject to ordinary income taxes.

Inheritances are taxable on the state level in some US states

While inheritances are not considered income for federal tax purposes, they are considered taxable on the state level in some US states. As of 2024, six states impose an inheritance tax: Iowa, Kentucky, Nebraska, New Jersey, and Pennsylvania. Maryland is the only state that levies both an inheritance tax and an estate tax.

Each state has different exemptions and tax rates. For example, in Nebraska, parents, siblings, and other close relatives can inherit $40,000 tax-free and pay a 1% tax on the market value of inherited property over that amount. In contrast, non-relatives pay an 18% tax on amounts over $10,000. In New Jersey, surviving spouses, parents, children, and grandchildren are exempt from the tax, while other beneficiaries may be taxed at a rate of up to 16%.

It is important to note that the federal government does not impose an inheritance tax, but it does have a federal estate tax for estates worth more than a certain amount. This tax is separate from any state-level inheritance taxes and is paid by the estate itself before assets are distributed to heirs.

Earnings made off an inheritance are taxable

While inheritances are not considered income for federal tax purposes, earnings made off an inheritance are generally considered taxable. This includes interest income, dividends, and capital gains.

For example, if you inherit a house and rent it out to tenants, you must pay income tax on the rent payments you receive. Similarly, if you inherit a bank account, you don't pay income tax on the funds in the account, but if they start earning interest, the interest payments are your taxable income.

It's important to note that the taxation of earnings made off an inheritance may depend on the state in which you reside, as some states have their own tax laws and exemptions.

Inherited retirement accounts are taxable

While beneficiaries generally don't have to pay income tax on money or other property they inherit, inherited retirement accounts are an exception to this rule. Whether an inherited account is taxable depends on the kind of account.

Tax-Deferred (Traditional) Retirement Plans

The money contributed to traditional IRAs and 401(k) plans is generally not taxed before it is put in. Either contributions are made with pre-tax dollars, or the contributor gets a tax deduction for the contribution. Income tax on the funds is deferred until the money is withdrawn from the account, either by the original contributor or by the person who inherits the account.

A beneficiary who withdraws money from an inherited account must report that money as ordinary income. The tax will be due with the person's regular annual income tax returns (both state and federal).

Surviving spouses who inherit a retirement account can defer the tax by rolling over the account into a retirement account of their own. Other beneficiaries can change the account into an "inherited IRA" and withdraw the money over several years, spreading out the income tax as well, but, with a few exceptions, they must withdraw the full amount within ten years.

Roth Retirement Plans

Money that a beneficiary withdraws from a Roth IRA or 401(k) plan is generally not taxable income. This is because Roth accounts are funded with money that has already been taxed.

However, if the money was contributed by the person who created the Roth account (rather than being a return on the investment of contributed funds), or if the account was opened and contributed to at least five years earlier, then the beneficiary does not have to pay income tax on the withdrawal.

Other Inheritance and Taxes

While inheritances are not considered income for federal tax purposes, any income produced by that asset is taxable income. For example, if you inherit a house and rent it out to tenants, you must pay income tax on the rent payments you receive. Similarly, if you inherit a bank account, you don't pay income tax on the funds in the account, but if they start earning interest, the interest payments are your taxable income.

There is no federal inheritance tax in the US, but some states do impose one. As of 2024, six states have an inheritance tax in place: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Inheritances can impact Medicaid eligibility

If you inherit money, you may no longer be eligible for Medicaid and may have to pay back Medicaid for any healthcare services received. If you fail to report an inheritance, Medicaid will seek repayment for any benefits provided during the months you didn't disclose the inheritance.

If you are a beneficiary or heir expecting to receive money or assets soon, it's best to plan ahead and consult with an estate planning attorney to create the best strategy. You must report the inheritance to the Social Security Administration and your state's Department of Children and Family Services. Failure to do so can result in steep penalties, and your state may sue you or put a lien on your property to reclaim Medicaid dollars.

If you inherit money, it will be considered income in the month it is received. Unless the inheritance is very modest, it will likely push you over the income limit, resulting in Medicaid ineligibility for that month. If the money is spent in its entirety during the month of receipt, you will be eligible for Medicaid again the following month. Any remaining inheritance will count as assets the following month and may cause you to be asset-ineligible.

There are several ways to spend down an inheritance to meet Medicaid's asset limit without violating the Look-Back Rule, including:

• Paying off debt
• Prepaying for funeral and burial costs by purchasing an Irrevocable Funeral Trust
• Buying new household furnishings or appliances
• Making home modifications

If you receive Medicaid benefits and inherit money or assets, you have limited choices. If the inheritance is large, you may decide to pay for your healthcare out-of-pocket or through another health insurance plan. If you want to preserve your Medicaid eligibility, you can accept the inheritance and then spend it down or implement planning strategies with the help of a Professional Medicaid Planner.

Frequently asked questions