I received an inheritance: How is this money taxed?

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The amount of federal estate tax typically is determined by the amount of assets within the estate and the relationship of the beneficiaries to the deceased.

Spouses and nonspouses

Spouses typically may inherit an unlimited amount of assets free of federal estate taxes. Estates bequeathed to nonspouses, in contrast, may be subject to federal estate taxes and state estate and/or inheritance taxes depending on the level of assets within the estate.
For nonspousal heirs, in 2017, the federal estate tax is levied at a maximum rate of 40% after a $5.49 million exemption (less any amount of the exemption used during the deceased's lifetime). For estate tax purposes, heirs typically value assets at the fair market value on the date of the deceased's death.
Note that some states impose estate and/or inheritance tax thresholds and tax rates that differ from those at the federal level. An estate planning attorney can advise you on taxation issues in your area.

Special rules for retirement accounts

In most instances, spouses who inherit individual retirement accounts (IRAs) may treat the IRA as their own and must begin required minimum distributions (RMDs) by April 1 of the year after the year in which they reach age 70½. RMDs, which are taken annually thereafter,Footnote 1 are taxed as ordinary income.
Nonspouses, in contrast, may not delay RMDs until they reach age 70½. A nonspouse may transfer the decedent's IRA assets into an IRA held in the nonspouse's name (called an "inherited IRA"). When taking distributions from an inherited IRA, which are taxed as ordinary income, a nonspouse has two options. As one option, the nonspouse may empty the inherited IRA over a five-year period. A second option available to a nonspouse is to take annual distributions, with the amount determined by the inherited IRA balance and the nonspouse's life expectancy (or, if longer, the life expectancy of the decedent account owner if the decedent account owner reached age 70½ prior to his or her death).Footnote 2 The latter strategy may permit a larger portion of the account to remain invested and subsequently provide the potential to grow tax deferred.
Similar rules apply to employer-sponsored retirement plans, such as 401(k) plans or 403(b) plans. If you inherit assets that are within an employer-sponsored plan, you may want to contact the sponsoring employer to determine rules affecting beneficiaries.
Estate and inheritance taxes are complicated issues. When determining how they apply to your situation,Footnote 3 an experienced estate planning lawyer could be your most valuable asset.

Footnote 1 If you delay your first RMD to the year after you turn age 70½, you will be required to take two RMDs in that calendar year.

Footnote 2 If the decedent account holder reached age 70½ but did not take an RMD in the year of death, an RMD must be taken from the inherited IRA by December 31st of the year the decedent account holder died.

Footnote 3 There is another level of tax (referred to as the "generation-skipping transfer tax") that might apply if grandchildren are involved.

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