Wealth Events: Inheritance
Quick Answer
Inherited taxable securities receive a stepped-up cost basis to fair market value on the date of the decedent's death, erasing built-in gains for income-tax purposes. Inherited retirement accounts do NOT receive a step-up. Traditional IRA and 401(k) distributions to beneficiaries remain ordinary income. Inheritance itself is generally not subject to federal income tax.
Beyond retirement distributions, the Series 6 exam tests how inherited securities are taxed when a customer receives them through an estate. The key concept is the step-up in cost basis, which differs dramatically between inherited taxable accounts and inherited retirement accounts.
How does the stepped-up cost basis work on inherited securities?
When a customer inherits stocks, mutual funds, or other securities from a decedent, the beneficiary's cost basis is reset:
- The beneficiary's basis is the fair market value (FMV) on the date of the decedent's death
- Alternatively, the estate may elect the alternate valuation date (AVD), which is 6 months after the date of death
- Post-death appreciation is measured from this stepped-up basis
- Any built-in gain that existed at the time of death is erased for income-tax purposes
Think of it this way: Imagine Grandma bought mutual fund shares for $10,000. By the time she passes, they are worth $50,000. If she had sold them, she would have owed tax on $40,000 of gain. When the heirs inherit the shares, their new basis is $50,000 (the FMV at death). The $40,000 of built-in gain disappears, and only appreciation from $50,000 forward is taxable.
Is inherited property subject to federal income tax?
- Inheritance itself is not subject to federal income tax
- Federal estate tax applies only if the estate exceeds the federal exclusion (which is indexed annually)
- Most states impose no inheritance tax on recipients, though a handful do
- Estate and gift taxation use a unified lifetime exclusion; the annual gift exclusion is separate and does not count against the lifetime exclusion unless exceeded in a given year
How are inherited retirement accounts taxed differently?
Retirement accounts do NOT receive a step-up in basis. This is the single most important inheritance distinction on the exam.
| Inherited Account Type | Tax Treatment |
|---|---|
| Taxable brokerage account (stocks, mutual funds) | Step-up in basis to FMV at date of death; only post-death appreciation is taxable |
| Inherited Traditional IRA / 401(k) | Distributions are ordinary income to the beneficiary; NO step-up applies |
| Inherited Roth IRA | Qualified distributions remain tax-free; non-spouse beneficiaries subject to SECURE Act 10-year rule |
Additional rules for inherited retirement accounts:
- Inherited Traditional IRAs and 401(k)s retain their pre-tax character
- Distributions to the beneficiary are taxed as ordinary income, not capital gains
- The SECURE Act 10-year rule still applies (see the Transfers, Rollovers, and Distributions section)
Exam Tip: Gotchas
- The step-up in basis applies to inherited non-retirement securities. It does NOT apply to inherited Traditional IRAs or qualified plan accounts. Those distributions are taxed as ordinary income to the beneficiary at their own rate. A question asking whether an heir can "sell grandma's inherited IRA shares tax-free using the step-up" is a classic trap.
- The alternate valuation date is 6 months after death, not 9 months (the 9-month number is the estate tax return filing deadline, a different concept). AVD can only be elected by the estate if it reduces both the gross estate and the estate tax owed.