Many people spend their lives building wealth not only to support themselves in retirement or during times of incapacity, but also to leave something meaningful to their families. This goal of passing wealth to the next generation often raises an important estate planning question related to inheritance taxes: Will my children owe taxes on the assets they inherit when I die?
The answer is more complex than it first appears. Most people worry about estate taxes, but for the vast majority of families, the federal estate tax is not an issue. In fact, fewer than 0.1% of estates were projected to owe federal estate taxes in 2025. Additionally, Alabama does not impose an estate or inheritance tax. That said, estate taxes are only one possible tax concern. Far more beneficiaries will encounter income taxes on inherited assets than estate or inheritance taxes.
Estate Taxes
The One Big Beautiful Bill Act (OBBBA) permanently set the federal estate and gift tax exemption at $15 million per individual, effective January 1, 2026. This exemption is indexed for inflation in future years. In practical terms, an individual can transfer up to $15 million during life or at death without incurring federal estate or gift tax. Married couples can use portability to combine their exemptions, allowing them to shield approximately $30 million from federal estate and gift taxes.
Because the exemption is so high, very few estates are subject to the federal estate tax. However, for estates that exceed the exemption amount, careful planning is essential, as the tax rate on amounts above the exemption can reach 40%.
Currently, only 16 states and the District of Columbia impose an estate tax or inheritance tax. Alabama does not. However, individuals who live in, or own property in, states with these taxes should be especially cautious. State-level exemptions are often much lower, and tax rates can reach 20% on amounts above the exemption.
Income Taxes on Inherited Assets
Inheritances are generally not considered taxable income for federal income tax purposes, so most inherited assets do not need to be reported on a beneficiary’s income tax return. However, certain types of inherited assets are subject to income tax, most notably tax-deferred retirement accounts.
As traditional pensions have largely been replaced by 401(k)s and similar plans, tax-deferred retirement accounts are often one of the largest assets a person owns aside from their home. When funds are withdrawn from an IRA, 401(k), or 403(b), income taxes are due at the account holder’s applicable tax rate. The same rule applies when beneficiaries withdraw funds from inherited retirement accounts.
With limited exceptions for spouses and minors, beneficiaries are generally required to withdraw the entire balance of an inherited tax-deferred retirement account within ten years. These withdrawals are taxed at the beneficiary’s own income tax rate and can significantly increase their effective tax burden during those years.
Capital Gains Taxes and the Step-Up in Basis
Another common concern is whether children will owe taxes if they sell an inherited home. Historically, many people purchased homes decades ago for relatively modest prices compared to their value at the time of death. Fortunately, when a home is inherited and sold shortly after death, there is often little to no capital gains tax owed.
This favorable result is due to the step-up in basis. The tax basis of an asset is generally what the owner paid for it, plus certain improvements. For example, if a home was purchased for $200,000 and later appreciated to $800,000, there would ordinarily be $600,000 of built-in capital gains subject to tax upon sale. However, at death, the asset’s basis is adjusted—or “stepped up”—to its fair market value at that time. In this example, the basis becomes $800,000, meaning that if the home is sold for that amount, no capital gains tax is due.
Be Sure You’re Following Current Law
It is important to note that tax laws can change. Some policymakers have proposed limiting the step-up in basis or treating death as a taxable event for capital gains. If such changes were enacted, highly appreciated assets could create significant tax liabilities for heirs. For this reason, it is always wise to consult with an attorney or tax professional when planning an estate – and to review your estate plan periodically to ensure it’s up-to-date and based on the most recent applicable laws. If it’s time for you to enlist some help, contact our estate planning attorneys.