Retirees often believe that an inheritance won’t affect their Social Security taxes because the money they receive generally isn’t taxable. Withdrawing or earning taxable returns from that money, however, could increase your income and make a larger portion of your benefits taxable. Here’s how a $400,000 inheritance could lead to a higher tax bill and what you can do to reduce it.
How an Inheritance Could Increase Your Tax Bill
After you receive inherited money or property, any income it generates could be subject to federal income tax. Interest, dividends, investment profits and withdrawals from inherited retirement accounts may increase your income. This can also make a larger portion of your Social Security benefits taxable, which means that you would owe taxes on both.
Some of this income is taxable when you receive it, while other amounts aren’t taxed until you sell an investment or withdraw money from an account. The table shows how each type of asset could affect your federal income taxes:
| Type of Inheritance | Potential Tax Impact |
|---|---|
| Cash | Interest earned after receiving the money may be taxable. |
| Stocks and other investments | Dividends and profits from selling investments could be taxable. |
| Traditional inherited IRA | Withdrawals are usually taxed as ordinary income. |
| Roth inherited IRA | Withdrawals are typically tax-free if certain requirements are met. |
| Home or other property | Selling for more than its tax basis might result in capital gains tax. |
The IRS uses provisional income to determine how much of your Social Security benefits are taxable. This includes your adjusted gross income, tax-exempt interest and half of your annual benefits. For a single filer, up to 50% of Social Security benefits can be taxable when provisional income exceeds $25,000, and up to 85% can be taxable when income is over $34,000. 1
To show how this works, let’s assume that you withdraw $30,000 from an inherited traditional IRA. That amount would usually get added to your taxable income for the year. The withdrawal also increases your provisional income, which could make more of your Social Security benefits taxable. As a result, you may owe federal income tax on both the IRA withdrawal and a larger portion of your benefits.
A financial advisor may help time withdrawals from inherited accounts to limit taxes on Social Security benefits.
How Much Social Security Taxes You Could Owe With an Inheritance
If you are 62, receive $24,000 annually in Social Security retirement benefits and earn another $15,000 in taxable income, a $400,000 inheritance could change your tax bill. The amount depends on whether you get cash, withdraw money from an inherited traditional IRA or earn taxable investment income.
The table compares these three situations, assuming you have no tax-exempt interest. Each calculation starts with the same $15,000 in other income and $24,000 in annual retirement benefits:
| Income and Tax Calculation | $400,000 Cash Inheritance | $40,000 Inherited IRA Withdrawal | $20,000 Investment Income |
|---|---|---|---|
| Other annual income | $15,000 | $15,000 | $15,000 |
| Income from inheritance | $0 | $40,000 | $20,000 |
| Half of Social Security benefits | $12,000 | $12,000 | $12,000 |
| Provisional income | $27,000 ($15,000 + $12,000) | $67,000 ($15,000 + $40,000 + $12,000) | $47,000 ($15,000 + $20,000 + $12,000) |
| Taxable Social Security benefits | $1,000 | $20,400 | $15,550 |
| Total taxable income before deductions | $16,000 ($15,000 + $1,000) | $75,400 ($15,000 + $40,000 + $20,400) | $50,550 ($15,000 + $20,000 + $15,550) |
With the cash inheritance, your taxable income before deductions is $16,000. The inherited IRA withdrawal increases that amount by $59,400, while the investment income raises it by $34,550.
The IRA withdrawal also leaves you with $24,850 more taxable income than the investment gains. These differences, however, do not represent the additional federal taxes you would owe. Your actual tax bill depends on your deductions and the federal income tax bracket.
How the Timing of Inherited Income Can Affect Taxes
The timing of withdrawals and investment sales can affect your annual tax bill. Spreading taxable income across different years may help limit increases in your federal income tax bracket and the amount of your Social Security benefits subject to tax.
However, inherited IRA rules can restrict when you take withdrawals. Many non-spouse beneficiaries must empty an inherited IRA within 10 years, and some have to take annual required minimum distributions (RMDs). Review these requirements before planning withdrawals across multiple tax years. A financial advisor can also help you compare withdrawal schedules to determine which could result in a lower tax bill.
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