Many investors use mutual funds throughout their lives to invest. When it comes time to sell mutual funds, dealing with taxes can be complicated, especially if you've reinvested dividends and capital gains distributions into additional shares. For those inheriting mutual funds, the tax aspects are actually much simpler. Let's take a look at some of the tax implications of inherited mutual funds.

New tax basis for inherited mutual fund shares in taxable accounts
The reason why taxes on inherited mutual funds aren't as complicated has to do with a tax law known as the basis step-up rule. Many mutual fund owners make multiple purchases of funds over the years, and ordinarily, they'd need to account for every single purchase when they sell their shares and calculate their gains. That's a huge hassle that many investors struggle to do correctly.

For inherited mutual fund shares in regular taxable accounts, the tax basis gets stepped up to whatever their value was on the date of death. That's true for all fund shares, regardless of when they were bought, or whether they were obtained through outright purchase, or from reinvestment of fund distributions.

The net effect of the basis step-up rule is that, if you sell inherited fund shares shortly after death, you'll likely have only minimal gain or loss as long as the fund's share price hasn't moved dramatically in that short period of time. That can save you a huge amount of money compared to the potential tax liability that the deceased person would have paid on a sale.

Inherited mutual fund shares in IRAs or other retirement accounts are more complicated
Unfortunately, mutual funds held in retirement accounts have different rules. They don't get a basis step-up, but generally, the distributions follow the same rules as they would for the original owner.

If the account is a traditional IRA, 401(k), or other standard employer retirement plan, then the sale of the funds inside the retirement account won't trigger tax, but the distribution of the proceeds will be taxable income to the heir. If the account is a Roth IRA, Roth 401(k), or other Roth-eligible employer plan funded with after-tax contributions, then the distributions won't trigger taxes.

Estate taxes
Funds in both retirement accounts and regular taxable accounts are generally included in the deceased person's estate. However, estate taxes are paid by the estate; by the time you receive the inherited mutual fund shares, any taxes typically will have been taken out of your bequest already.

There are no inheritance taxes at the federal level, but some states still impose an inheritance tax on bequests. In that case, you might owe money from your mutual fund inheritance. Check with your state revenue department to see whether it has inheritance taxes on the books.

Inheriting funds can seem like a tax nightmare, but it's usually much easier than you'd think. The basis step-up rule makes things both simpler and less taxing for heirs.

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