Not All Inheritances Are Created Equal
Inheriting $1 million doesn’t always mean receiving $1 million after taxes.
What This Means
If you’re fortunate enough to inherit money, there’s something important you need to understand.
Not all inheritances are created equal.
You could inherit $1 million in a traditional IRA, $1 million in a Roth IRA, or $1 million in a taxable investment account.
On paper, they’re all worth $1 million. But what you actually get to keep could be very different.
Here’s why.
Traditional IRA: That money generally hasn’t been taxed yet. Most children inheriting an IRA have 10 years to empty the account, and withdrawals are generally taxed as ordinary income. Depending on how much they’re earning, those withdrawals could push them into a higher tax bracket.
Roth IRA: Completely different story. The taxes have already been paid. Assuming the Roth meets the five-year rule, your kids can generally withdraw that money income-tax-free. They typically still have 10 years to empty the account, but that’s potentially 10 more years of tax-free growth.
Taxable Investment Account: This one has another advantage. When you inherit stocks or other investments, you generally receive what’s called a step-up in cost basis. That means years of investment gains could potentially be wiped away for capital gains tax purposes.
Think about that.
Three accounts. Same $1 million balance. Three very different tax outcomes.
And this is where financial planning comes into play.
If you’re leaving money behind, should you spend down your IRA first? Preserve your Roth? Consider Roth conversions while you’re alive?
The answer depends on your situation, your taxes, and what you’re trying to accomplish.
And make no mistake about it. Inheriting money, whether it’s pre-tax or after-tax, is a generous gift.
But understanding how that money is taxed can make a big difference.
Because it’s not just about how much money you leave behind. It’s about how much your loved ones actually get to keep.
Common Questions
Should I leave an inherited Roth IRA untouched for 10 years?
Potentially, yes. Unlike a traditional IRA, where withdrawals are generally taxable, an inherited Roth IRA can continue growing tax-free. That means you could leave the money invested for up to 10 years and potentially withdraw a much larger amount income-tax-free, assuming the Roth meets the five-year rule.
Is it better to leave your children a Roth IRA or a traditional IRA?
From your children’s income tax perspective, a Roth IRA can be more attractive because qualified withdrawals are tax-free. But that doesn’t automatically mean converting your traditional IRA to a Roth is the right move. You also need to consider the taxes you’d pay on the conversion, your current tax bracket, and your children’s future tax situation.
Does the step-up in cost basis apply to all inherited investments?
Not all investments qualify. Stocks, ETFs, mutual funds, and real estate held in taxable accounts generally receive a step-up in cost basis when inherited. However, traditional IRAs and 401(k)s do not. That’s an important distinction when deciding which assets to leave to your children.
What is the most important thing to know when inheriting money?
Understand what type of account you’re inheriting and how it’s taxed before making any decisions. A traditional IRA, Roth IRA, and taxable investment account are all treated differently. Knowing the rules can help you avoid unnecessary taxes and make the most of the money you’ve inherited.
Remember This:
Not all inheritances are created equal.
Keep Learning:
Inherited IRA Strategy: Understand the 10-year withdrawal rule and how taxes can affect the money you inherit.
How IRAs Are Taxed — And How to Pay Less: Learn how traditional and Roth IRAs are taxed and why planning ahead matters.
Transfer on Death (TOD): Learn how beneficiary designations can help investments pass directly to your loved ones without probate.