If you inherit $50,000 from your mother, will you have to pay income-tax on it? What about if you won $50,000 on a lottery scratch ticket? They seem similar, but the results are quite different. Under the Federal Tax Code any receipt of money or property is taxable unless it is specifically exempted from being taxable. So, those lottery winnings are taxable income and you’ll have to give Uncle Sam his share of that fifty thousand. But, there is a major exemption in the Tax Code: the receipt of a gift or inheritance is not a taxable event for income-tax purposes. So, that fifty grand from mom is tax free.

It doesn’t matter if Mom gave you the money while she was alive, or if you inherited it from her estate after she died, if it is truly a gift or inheritance, then it is not taxable income from Federal Income-Tax purposes. Some states may treat this differently (though most do not), and you may want to consult your tax advisor if you receive a gift, so it is properly reported if necessary. And, if you are getting paid for a service, then it’s not a gift so it will be taxable (for example, if you provide care-giving to your mother and she pays you an hourly fee for it, that isn’t a gift, it’s income).

So, the rule is that the receipt of a gift is not taxable, but nothing is ever simple in today’s world, so you have to be aware of certain situations that may have a different result. One such situation is with savings bonds. Bonds have earned interest and the income-tax is not paid until the bond is cashed. Many parents buy bonds either in joint names with a child or with a child named as death beneficiary. The bond passes easily to a survivor, but when you cash in the bond, you will realize the taxable income for the accrued interest. In this case, it’s not the gift that is being taxed, but the interest income that has not yet been taxed until you cash in the bond.

Another exception is retirement funds – IRAs and 401k plans. These also have built-in income-tax issues that cannot be avoided. There is no gift tax on the inheritance of an IRA, but when you withdraw the funds, it will be counted as ordinary income and taxable to you. A counter-exception is the new Roth IRA that does not have a tax liability.

From the recipient’s point of view, a gift or inheritance is a great thing. It is free money without any income-tax liability. Things can be different from the giver’s point of view, however. Gifts under the annual exemption amount of $13,000 are tax-free to the giver. And, any gifts under the lifetime exemption amount (currently over $5 million) are also tax-free. But, gifts can change your estate-tax situation, so you should consult with your advisors before making any large gifts.  Also, state tax laws vary so you might want to consult an accountant in your state if you are not sure.  Consult an accountant anyway, why would you do your own taxes?  See our website listing of other professionals from some CPAs that we know.

And, of course, things change.  The income-tax and gift/estate-tax rules may change next year, unless Congress passes a bill to change them in some other way.  The “Bush Tax Cuts” are set to expire on 1/1/13.  Stay tuned to see what happens.    Here is a link to the IRS FAQ on gift-taxes:  http://www.irs.gov/businesses/small/article/0,,id=108139,00.html.

If you have any questions, please consult with your friendly neighborhood Elder Law Attorney!