Taxes on Inherited Money From Non-Qualified Investments

In tax terms, qualified means the investments are held in an account designated by law as a tax-advantaged retirement savings account. Two commonly owned examples of qualified money would be individual retirement accounts and employer-sponsored 401(k) accounts. Both contributions and earnings in a qualified account are sheltered from income taxes. Stocks, bonds and other investment instruments not owned in a designated qualified account would be non-qualified investments. The original owner of these investments paid taxes on dividends or interest as they were earned, and on any capital gains resulting from selling investments for a profit.

The heir to non-qualified investments receives the investments with a potentially significant tax benefit. Inherited investments pass to the heirs with a cost basis set at the value of the investments on the date of the original owner's death. This step-up in basis means the heirs will pay no taxes on the gains generated by increases in the investment value before the owner died. For example, say your uncle paid $1,000 for some stock that was worth $50,000 when he died and left the shares to you. If you sell the fund shares, your cost basis would be the $50,000 and you would pay taxes on the gain between the sales value and $50,000. The $49,000 gain your uncle earned on the fund shares will never be taxed.

Annuities are tax-advantaged savings investments that can be purchased with either qualified money -- such as with IRA funds -- or non-qualified money. In either case, the earnings generated by the annuity grow tax-deferred until withdrawals are taken from the annuity. A non-qualified annuity lets the buyer shelter interest or investment gains from taxes to let the annuity value grow and increase without paying any taxes on the growth.

In a non-qualified annuity, the original investment amount passes to the heirs without any taxes due, but taxes must eventually be paid on the gains in the contract. A spouse who inherits the non-qualified annuity will have the option to continue the annuity and delay the payment of taxes. Any non-spouse heirs will be required to receive the value of the annuity and pay taxes on the tax-deferred gains. Annuities are transferred to the heirs through beneficiary designations and typically are not handled by the estate.