As a financial advisor who has worked with Colorado residents for over 20 years, I’ve answered a lot of tax questions. And with the Great Wealth Transfer on the horizon…I expect to answer many more.
If you’ve received an inheritance, you might have visions of paying off student debt or taking that bucket-list vacation. But before you start writing those checks (yes, I just dated myself there), you need to understand the tax implications of your inheritance – otherwise, you might be in for a bad surprise.
Let’s talk about which assets are likely to be taxed, how federal and state laws apply, and steps you can take to manage your inheritance in a tax-efficient way.
The Basics of Inheritance Taxes: Federal vs. State
First, let’s break down inheritance tax basics at both the federal and state levels. An inheritance tax is imposed on individuals who receive assets from a deceased person’s estate. However, there is no federal inheritance tax in the United States, meaning you won’t owe taxes on inherited assets solely due to federal regulations.
For Colorado residents, there’s good news: Colorado does not impose an inheritance tax. This means that when you inherit money or assets from a family member, you generally don’t owe Colorado state tax just because of the inheritance itself.
However, if you’re a Colorado resident inheriting assets from someone who lived in a state with an inheritance tax (like Pennsylvania or Kentucky), you may still be liable for inheritance taxes in that state.
Estate Taxes vs. Inheritance Taxes: What’s the Difference?
Essentially, inheritance tax is paid by the beneficiary who receives the assets, while estate tax is applied to the estate itself before any distribution to heirs. This distinction is especially relevant for large estates that surpass certain values, though here in Colorado, residents benefit from a major tax break: Colorado doesn’t have a state-level estate tax. While there is a federal estate tax, it only applies to very large estates—those over $12.92 million in 2023, or $25.84 million for married couples. This means that unless an estate is exceptionally large, federal estate taxes won’t impact most inheritances for Coloradans.
However, while you may be free from state inheritance or estate taxes, there are still some tax considerations to keep in mind for inherited assets.
- Income from Inherited Assets: While inheriting the assets themselves isn’t taxable, any income you earn from them is. For example, if you inherit a rental property, the rental income is subject to regular income tax.
- Capital Gains on Inherited Assets: If you inherit stocks, property, or other investments, you receive them with a “stepped-up basis.” This means the cost basis of the asset is adjusted to its fair market value at the time of the original owner’s death. If you sell the inherited asset for more than this stepped-up basis, you’ll owe capital gains tax only on the amount above this new value. This can be a significant advantage when inheriting assets that have appreciated over time.
- Inherited IRAs and Retirement Accounts: For traditional IRAs, 401(k)s, and other retirement accounts, inheritors typically must pay income tax on withdrawals. Colorado does not add a separate state tax on these withdrawals, but you’ll pay federal income tax on the amount you withdraw from an inherited IRA or retirement account.
Keep in mind that you must make withdrawals and pay taxes according to a specific timeline. This has changed a lot in the last five years: how much and when depends on when the original owner was born, when they died, and your relationship to them. There are significant penalties for not meeting the schedule. It is also wise to employ a strategy on withdrawals so that you don’t end up in a higher tax bracket and owe more than you have to. In other words…this is probably a good time to speak with a professional.
Planning Ahead
While Colorado’s tax laws offer residents a tax-friendly inheritance environment, it’s still wise to consult a financial advisor to understand how your specific inheritance might impact your finances. An advisor can also help you create a plan so that you don’t blow through that inheritance without considering your future.
Inheriting assets can be life-changing; understanding the tax impact is a key part of managing this transition. CLICK HERE to make an appointment.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
