Avoid These Inheritance Money Tax Traps
Don't Be Caught off Guard by Inheritance Taxes
Receiving a family inheritance can be bittersweet. While you're receiving money, you're losing a loved one who cared enough about you to include you in their will. Because receiving an inheritance can come with such a flood of contradictory emotions, it can also lead to expensive missteps. When you receive notification of an inheritance, take some time to plan ahead and protect your newly acquired assets by avoiding these tax mistakes.
Cashing In Before Figuring Out Inheritance Tax
Before you seek a payout of a family inheritance, determine whether you will have to pay taxes and how much. The amount you will pay in tax on inheritance money depends on the type of asset that was passed down to you, the account in which it was held, and the timeline on which you choose to receive your payout.
Taxes on Inherited Retirement Accounts
Many unsuspecting heirs liquidate an inherited retirement account expecting to pocket the entire account balance. If your inheritance money comes from a retirement account to which pre-tax dollars were contributed, such as a traditional 401(k) or individual retirement account, state and federal income tax on the money has not yet been paid.
When a beneficiary withdraws money from these accounts, the amount must be included as taxable income on a tax return, which can substantially increase a tax bill and diminish a family inheritance. In contrast, you can avoid paying inheritance tax when you take a distribution from an account funded with post-tax dollars, such as a Roth 401(k) or Roth IRA.
You may incur a hefty tax bill if you take the entire balance of an inherited retirement account in a single year, but if you withdraw some this year and some in January of next year, you can spread the distribution and the tax burden over two tax years.
Spouse and non-spouse beneficiaries can leave a traditional 401(k) or a Roth 401(k) as is or roll it over to an inherited IRA account. By making this move, you won't feel pressured to cash out inheritance money immediately. Instead, you only have to take out a required minimum distribution each year, which is the minimum amount you have to withdraw from retirement accounts after reaching 70 1/2 years of age. In many cases, this approach will allow you to divide the income and taxes on your inheritance over the remainder of your life and avoid paying high taxes on inheritance money in any single year.
Taxes on Inherited Investments
For mutual funds or stocks that are passed down to you in taxable accounts, such as brokerage accounts in your name, the tax rules are different. The value of these assets for inheritance tax purposes is usually the "stepped-up" cost-basis: the fair-market value of the assets on the deceased person's date of death.
Using the stepped-up cost basis, you will incur a capital gain or a loss depending on the value of the asset when you sell it. Unlike capital losses, which can lower your income and reduce the tax you owe, capital gains can increase your income and your tax bill.
To predict the tax burden of withdrawing assets in inherited accounts, use tax software or ask a CPA or financial adviser to conduct a tax projection, an estimate of what you will pay in taxes this year based on investment account statements and other financial documents.
Taxes on Life Insurance Proceeds
The good news: If you receive life insurance proceeds as a beneficiary of an insured individual who died, this amount is almost always tax-free. You will not have to report life insurance payouts received as taxable income on your tax return. However, the interest you receive on life insurance proceeds is considered taxable income.
Paying Debts You Don't Owe
Some creditors may attempt to collect the debts of a deceased person from family members. These claims should be made against the estate, not against you. In general, you are not personally responsible for the debts of someone from whom you receive an inheritance. Regard any such demands with skepticism.
However, debts are not automatically cleared when someone dies. If the estate has the money to pay off the debt, it generally must do so, which can substantially reduce the inheritance money of the heirs. If, however, the estate can't pay the debt, then it may go unpaid.
The proceeds from a life insurance policy generally aren't taxable, but the interest is.
Not Evaluating All Options When You Inherit a Home
When you inherit a house, your highest priority should be to secure and maintain the home until you decide what to do with it. Can family or neighbors help? Do you need to install a security system? Can someone else live in and look after the home if you can't? Maintaining the home while you determine what to do with it is the first step to preserving its value. Consider these other factors when deciding what to do with an inherited piece of property.
- Estimate what the home is worth. You can use an online resource such as Zillow to get an estimate of the home's value. However, online sites may not have up-to-date information on the property. A realtor familiar with the area will be your best resource.
- Determine if the home has a mortgage on it. If so, but the home is worth less than the remaining mortgage amount, you may decide that the best course of action is to let the house go to foreclosure, in which case you would stop making the mortgage payments. If the home's value less selling costs is more than the mortgage, you will need to maintain the mortgage payments while you prepare the property for sale. If you do not make the mortgage payments, the lender has the right to foreclose on the property.
- Consider selling the home. If you decide to sell the home, you'll need to figure out your inheritance tax burden. When you inherit a home, the value of the home on the deceased's date of death becomes the stepped-up cost basis for tax purposes. If the house is worth approximately $100,000 and you sell it eight months later for $110,000, you may have $10,000 in capital gains to report on your tax return. However, you may be able to exclude up to $250,000 of the gain if you have lived in the home for at least two of the five years before the sale. If there is a loss on the sale of the personal property, you will not be able to use it as a deduction. A good tax preparer can help you navigate these nuances in the tax code.
- Decide if renting out the home is an option. If you can't shoulder the inheritance tax burden of a property sale, you may wish to consider renting out the home. As an investment property, it may provide more financial benefits to you than what you can achieve if you sell it and invest the proceeds.
- Live in the home. If the home suits you more than the home you currently live in, you might want to live in the home. You would need to take out a new mortgage if there is still money owed on it. If the home is owned free and clear when you inherited it, you'll need to have a title search performed, transfer the title to your name, and pay any fees incurred for this service. You'll also become financially responsible for upkeep, taxes, homeowners association fees, and any other costs associated with owning the home.
If you're fortunate enough to inherit a fabulous piece of property, you don't necessarily have to sell it. If the property would be a great fit for you or would make an outstanding vacation home, talk to an accountant or financial adviser to see if there's a way for you to keep it.
Buying Dubious Financial Products
There are over 200,000 personal financial advisers in the U.S. The compensation of many of these advisers depends on successfully selling investment or insurance products. Upon finding out you have inheritance money and are not sure what to do with it, disingenuous dealers might sell you on a poor investment that could cost you a sizable portion of your inheritance.
For this reason, you shouldn't invest in or buy insurance products without going through a comprehensive financial planning process. If you know you are soon to receive an inheritance, start your search for a fee-only financial adviser. These professionals get paid to advise and help their clients plan for their financial futures. More importantly, they have a fiduciary responsibility to work in their clients' best interests and should help you decide what to do based exclusively on your current situation and future goals.
A financial planner can help you decide what to do with an inheritance, but look for one that charges a fee rather than one who makes a commission by selling you particular financial products.
Neglecting the Alternate Valuation Date for Large Inheritances
In addition to income tax, your inheritance will generally be subject to federal estate tax if the value of the estate is $11.7 million or higher in 2021.
For high-value inherited investments and property, the executor of the estate may have the option to use an alternate valuation date instead of the deceased person's date of death when valuing inherited assets. The alternate date is the earlier of six months after the deceased person's date of death or the date of the transfer of the assets.
This option is generally only permitted when:
- The estate is subject to estate tax.
- The estate's gross value and the estate tax liability would be lower on the alternate date than on the date of death.
In a declining real estate market, valuing inherited assets subject to the estate tax at the alternate valuation date can result in a lower asset value at the time of sale, which may help you reduce or avoid taxes on the estate and preserve more of your family inheritance.