Inheriting Mutual Funds: Basis, Capital Gains, and the 10-Year Rule

Mutual funds you inherit in a regular taxable brokerage account receive a stepped-up cost basis equal to their value on the date of death, which can erase most or all of the capital gains tax you would otherwise owe when you sell.¹ Mutual funds inside a Traditional IRA or 401(k) work very differently: withdrawals are taxed as ordinary income, and most non-spouse beneficiaries have ten years to empty the account.² The account type the funds were held in drives almost every tax question that follows, so start there before you make any decisions about selling or withdrawing.

Stepped-Up Basis on Funds From a Taxable Account

When mutual fund shares pass to you from a taxable brokerage account, the cost basis resets to the fair market value on the date the owner died.¹ All the unrealized gains that built up during the original owner’s lifetime are wiped out for tax purposes. You only owe capital gains tax on appreciation that happens after that date.

An example makes it concrete. The decedent bought shares for $10,000 over the years, and those shares were worth $50,000 on the day of death. Your basis is $50,000. Sell the next week for $50,200 and your taxable gain is $200, not the $40,200 the original owner would have reported.

The brokerage should update the basis when it re-registers the shares in your name, and the stepped-up figure should appear on the Form 1099-B you get when you sell. Check it. Brokerages sometimes carry over the decedent’s original cost by mistake, and if you file using the wrong number you’ll overpay with no automatic correction from the IRS.

Basis Can Also Step Down

The rule follows fair market value in either direction. If the shares were worth less at death than what the decedent paid, your basis is the lower figure. Shares bought for $50,000 and worth $35,000 at death give you a $35,000 basis. You cannot use the decedent’s original purchase price to claim a loss.

Community Property States Get a Double Step-Up

If you live in a community property state and your spouse dies, both halves of community-owned mutual fund shares receive a new basis at fair market value.³ In a common-law state, only the decedent’s half resets. The double step-up is a meaningful advantage for surviving spouses in California, Texas, Arizona, and other community property jurisdictions, and it applies as long as at least half the community interest was includible in the decedent’s gross estate.

Capital Gains Rates When You Sell

Any gain on inherited mutual fund shares from a taxable account is taxed at long-term capital gains rates no matter how soon you sell. Federal law treats inherited property as held for more than one year automatically.⁴ That classification matters because long-term rates are considerably lower than short-term ones.

For 2026, the long-term capital gains brackets fall roughly as follows:

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

Most beneficiaries land in the 0% or 15% bracket, especially since the stepped-up basis usually keeps the gain small.

The 3.8% Net Investment Income Tax

Higher-income beneficiaries may also owe the Net Investment Income Tax on gains from the sale. The surtax kicks in once modified adjusted gross income exceeds $200,000 for single filers or $250,000 for joint filers.⁵ Those thresholds aren’t indexed for inflation, so they catch more taxpayers every year. The tax applies to the lesser of your net investment income or the amount your MAGI exceeds the threshold, which can push the effective top federal rate on inherited fund gains to 23.8%.

Inherited Retirement Account Funds Are Taxed as Ordinary Income

Mutual funds held inside a Traditional IRA, 401(k), or similar tax-deferred account do not receive a stepped-up basis. The money was never taxed on the way in, so the entire distribution comes out as ordinary income to you.⁶ Depending on your total income, the federal rate can reach 37%.⁷ State income tax may apply on top.

Inherited Roth IRAs also sit outside the stepped-up basis system, but the result is far friendlier. Qualified distributions come out tax-free because Roth contributions were made with after-tax dollars. The distribution deadlines still apply; the income tax doesn’t.

The 10-Year Rule for Non-Spouse Beneficiaries

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 year following the year of death.² This replaced the older stretch-IRA approach that let non-spouse beneficiaries spread distributions over their own life expectancy.

An often-missed detail: if the original owner died after their required beginning date for RMDs, you also have to take annual minimum distributions during the ten-year window, not just empty the account by the end of year ten.⁸ If the owner died before reaching that date, annual withdrawals aren’t required and you can take distributions on any schedule, as long as the account is empty by the deadline.

Missing the ten-year deadline triggers a 25% excise tax on what should have been withdrawn. The penalty drops to 10% if you fix the shortfall within two years.²

Beneficiaries Who Are Exempt From the 10-Year Rule

Certain beneficiaries, called eligible designated beneficiaries, can still spread distributions over their own life expectancy:⁶

A surviving spouse, who has the broadest set of options
A minor child of the account owner, until reaching the age of majority, at which point the ten-year clock starts; this covers only the decedent’s own child, not grandchildren
A disabled or chronically ill individual
A person not more than ten years younger than the decedent

Everyone else, including adult children, grandchildren, friends, and most trusts, falls under the ten-year rule.

Options Specific to a Surviving Spouse

A surviving spouse has more flexibility than any other beneficiary.⁶ A spousal rollover moves the inherited funds into your own IRA and restarts the RMD clock entirely, so you don’t have to take required distributions until you reach age 73.² That’s usually the best choice for a spouse who doesn’t need the income right away. Keeping the account titled as an inherited IRA, by contrast, lets you take distributions immediately without the 10% early withdrawal penalty regardless of your age, which matters if you’re under 59½ and need the money.⁹ Following the ten-year rule is also available but rarely a spouse’s best move.

Deciding When to Sell or How to Spread Withdrawals

For a taxable account, the stepped-up basis opens 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 inherited fund doesn’t suit your goals, that’s the cheapest time to get out. Hold on, and any further appreciation becomes taxable when you eventually sell. If you do hold, treat the date of death as your starting line for tracking gains going forward.

For an inherited retirement account, the strategic question is how to spread withdrawals across the ten-year window so you don’t bunch income into a single bracket. Taking the whole balance in one year can push you into the 32% or 37% bracket. Spreading distributions keeps more of the money in lower brackets. Run projected numbers against your expected income each year before you set a withdrawal schedule. This is where most of the real tax savings on an inherited IRA come from, and it’s the step most beneficiaries skip.

Dividends Paid Between Death and Transfer

Mutual funds keep paying dividends after the owner dies. Any distributions made between the date of death and the date the account is re-registered in your name are generally income of the decedent’s estate, not yours, and get reported on the estate’s income tax return (Form 1041) if the estate’s gross income is $600 or more.¹⁰ Once the account is in your name, future distributions are your taxable income. Confirm with the executor and the brokerage that income has been split correctly based on the transfer date.

Forms You’ll See at Tax Time

Three IRS forms do most of the work when you report what you inherited.

Form 1099-B comes from the brokerage when you sell shares from a taxable account and should reflect the stepped-up basis. Report the sale on Form 8949 with “INHERITED” in the date-acquired column, then carry the totals to Schedule D.¹¹

Form 1099-R comes from the custodian when you take distributions from an inherited retirement account. The distribution code on the form tells the IRS what kind of withdrawal it was.¹²

If the 1099-B shows a wrong basis, don’t just accept it. You can correct the figure on Form 8949 using column (e) for cost basis and column (f) for an adjustment code.¹³

Federal Estate Tax Is a Separate Question

Don’t confuse the income tax on your inherited funds with federal estate tax. For 2026 deaths, estates valued at or below $15,000,000 owe no federal estate tax, and portability lets married couples effectively shield up to $30,000,000 combined.¹⁴ That exemption covers almost every estate. Even so, the income tax rules on inherited mutual funds apply in full: you still get the stepped-up basis on taxable account shares, and you still owe ordinary income tax on retirement account withdrawals.

1
Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent
2
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
3
Internal Revenue Service. Publication 555 Community Property
4
Office of the Law Revision Counsel. 26 U.S. Code 1223 – Holding Period of Property
5
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
6
Internal Revenue Service. Retirement Topics – Beneficiary
7
Internal Revenue Service. Federal Income Tax Rates and Brackets
8
Internal Revenue Service. Notice 2024-35 – Certain Required Minimum Distributions
9
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
10
Internal Revenue Service. Instructions for Form 1041 and Schedules A, B, G, J, and K-1
11
Internal Revenue Service. About Form 8949, Sales and Other Dispositions of Capital Assets
12
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
13
Internal Revenue Service. Instructions for Form 8949
14
Internal Revenue Service. What’s New – Estate and Gift Tax