Inheriting Mutual Funds: Stepped-Up Basis, Taxes, and the 10-Year Rule

Taxes on inherited mutual funds depend almost entirely on where the shares were held. Funds in a regular taxable brokerage account get a stepped-up cost basis equal to their fair market value on the date of death, which usually eliminates most or all of the capital gains tax on a lifetime of appreciation.1Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent Funds inside a Traditional IRA, 401(k), or similar tax-deferred account get no basis step-up; distributions come out as ordinary income, and most non-spouse beneficiaries must empty the account within ten years.2Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs Everything else follows from that split.

Taxable Accounts Get a Stepped-Up Basis

If you inherited mutual fund shares held in a taxable brokerage account, your cost basis resets to the shares’ fair market value on the date the previous owner died.1Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent All the unrealized appreciation that built up during the decedent’s lifetime disappears for tax purposes. You only owe capital gains tax on the change in value between the date of death and the date you sell.

An example makes the math obvious. The decedent bought fund shares for $10,000 over the years, and those shares were worth $50,000 the day they died. Your basis is $50,000. Sell a week later for $50,200 and your taxable gain is $200, not the $40,200 that would have been taxable to the original owner.

Check the number your brokerage puts on file. When shares are re-registered in your name, the firm should update basis to the date-of-death value, and that figure will flow onto any Form 1099-B when you sell. Brokerages sometimes carry over the decedent’s original basis by mistake. If that wrong number goes onto your return, you’ll overpay capital gains tax and the IRS won’t correct it for you.

Basis Can Step Down, Too

The reset works on fair market value in either direction. If the shares were worth less at death than the decedent originally paid, your basis is the lower value. Decedent paid $50,000, shares worth $35,000 at death: your basis is $35,000, and you cannot use the decedent’s $50,000 purchase price to claim a loss.

Community Property States Get a Double Step-Up

A surviving spouse in a community property state gets both halves of community-owned mutual fund shares stepped up to date-of-death value.3Internal Revenue Service. Publication 555 Community Property In common-law states, only the decedent’s half resets. This double step-up matters in California, Texas, Arizona, and the other community property jurisdictions. It applies as long as at least half the community interest was includible in the decedent’s gross estate.

Selling Inherited Fund Shares

Any gain on the sale of inherited mutual fund shares from a taxable account is taxed at long-term capital gains rates, even if you sell the day after you receive the shares. Federal law treats inherited property as held long-term automatically.4Office of the Law Revision Counsel. 26 U.S. Code 1223 – Holding Period of Property That’s a meaningful benefit, because long-term rates run well below ordinary income rates.

For 2026, the long-term capital gains rates and approximate income thresholds are:

  • 0% on taxable income up to about $49,450 single or $98,900 married filing jointly
  • 15% on taxable income from roughly $49,451 to $545,500 single or $98,901 to $613,700 married filing jointly
  • 20% on taxable income above those thresholds

Most beneficiaries land in the 0% or 15% bracket on inherited-fund gains, especially since the stepped-up basis usually leaves only a small gain to tax.

The 3.8% Net Investment Income Tax

Higher-income beneficiaries may also owe the 3.8% Net Investment Income Tax on gains from selling inherited fund shares. The surtax applies once modified adjusted gross income passes $200,000 single or $250,000 married filing jointly, and those thresholds aren’t indexed for inflation.5Internal Revenue Service. Topic No. 559, Net Investment Income Tax It hits the lesser of your net investment income or the amount by which your MAGI exceeds the threshold. In practice, the effective top federal rate on long-term gains from inherited funds tops out at 23.8%.

Retirement Account Funds Are Taxed Very Differently

Mutual funds held inside a Traditional IRA, 401(k), or similar pre-tax retirement account do not receive a stepped-up basis. The money in those accounts was never taxed on the way in, so every dollar you withdraw comes out as ordinary income on your return.6Internal Revenue Service. Retirement Topics – Beneficiary Depending on your total income, the federal rate can climb to 37%, plus any state income tax.7Internal Revenue Service. Federal Income Tax Rates and Brackets

Inherited Roth IRAs also sit outside the stepped-up basis system, but the tax outcome is friendlier. Because Roth contributions were made with after-tax dollars, qualified distributions from an inherited Roth come out tax-free. The withdrawal deadlines below still apply.

The 10-Year Withdrawal Rule

Under the SECURE Act of 2019, most non-spouse beneficiaries who inherit a retirement account must withdraw the entire balance by December 31 of the tenth calendar year after the year of death.2Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs The old “stretch IRA” approach that let non-spouse beneficiaries spread distributions across their own life expectancy no longer applies to most people.

One detail catches beneficiaries off guard. If the original owner had already reached their required beginning date for RMDs before dying, you must also take annual minimum distributions during years one through nine of the 10-year window, in addition to emptying the account by the end of year ten.8Internal Revenue Service. Notice 2024-35 – Certain Required Minimum Distributions If the owner died before their required beginning date, annual distributions aren’t required and you can withdraw on any schedule, as long as the account is empty by the deadline.

Miss the 10-year deadline and the IRS imposes a 25% excise tax on the amount that should have come out. That drops to 10% if you correct the shortfall within two years.2Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs

Who Escapes the 10-Year Rule

Certain beneficiaries, called eligible designated beneficiaries, can still stretch distributions over their own life expectancy:6Internal Revenue Service. Retirement Topics – Beneficiary

  • A surviving spouse, who has additional options described below
  • A minor child of the account owner, until reaching the age of majority (at which point the 10-year clock starts); this covers the decedent’s own child, not grandchildren
  • A disabled or chronically ill individual
  • Anyone not more than 10 years younger than the decedent

Adult children, grandchildren, friends, and most trusts fall under the 10-year rule.

Spouse-Only Options

A surviving spouse has the most flexibility of any beneficiary:6Internal Revenue Service. Retirement Topics – Beneficiary

  • Roll the inherited funds into your own IRA. This restarts the RMD clock; you won’t need to take required distributions until you reach age 73, the current RMD starting age. Usually the best choice when you don’t need the money soon.2Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
  • Keep it as an inherited account. This lets you take distributions right away without the 10% early withdrawal penalty regardless of your age, which matters if you’re under 59½ and need income.9Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
  • Follow the 10-year rule. Available, but rarely the best choice for a spouse.

Sell Now or Hold?

For taxable accounts, the stepped-up basis creates a clean exit window. Because your basis equals the date-of-death value, selling soon after inheritance usually produces little or no taxable gain. If the fund doesn’t fit your goals, this is the cheapest moment to get out. Waiting means any further appreciation becomes taxable when you eventually sell.

If you keep the shares, treat the date of death as your new starting line. Anything the fund gains from that point forward is your taxable gain when you sell, at long-term rates.

For inherited retirement accounts, the real planning question is how to spread withdrawals across the 10-year window to keep from stacking too much ordinary income into a single year. Pulling the whole balance out at once can push you into the 32% or 37% bracket; spreading distributions across all ten years often keeps more of the money in lower brackets. Sketch the numbers against your expected income each year before locking in a schedule. This is where inherited-IRA tax savings actually come from, and it’s the step most beneficiaries skip.

How to Report It All

A few IRS forms will come into play:

If the 1099-B shows the wrong basis, correct it on Form 8949 using column (e) for cost basis and column (f) for the adjustment code. Don’t accept a number you know is wrong.13Internal Revenue Service. Instructions for Form 8949

Federal Estate Tax Is a Separate Question

The federal estate tax and your income tax on inherited mutual funds are two different obligations. For deaths in 2026, estates valued at $15,000,000 or less owe no federal estate tax, and married couples can effectively double that through portability, sheltering up to $30,000,000 combined.14Internal Revenue Service. What’s New – Estate and Gift Tax The vast majority of estates fall below that threshold.

Even when no estate tax is due, the income tax rules for inherited funds still apply in full. You still get the stepped-up basis on taxable-account shares, and you still owe ordinary income tax on retirement-account distributions. The exemption blocks the transfer tax on the estate; it doesn’t change how the income from what you inherit is taxed on your personal return.