Avoid These Tax Traps for Inheritance Money

Don't let taxes on a family inheritance catch you off guard

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Receiving a family inheritance may seem like winning the lottery of life. But it can also lead to expensive missteps. Stretch inheritance money or other assets further by avoiding 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, such as a 401(k) or an IRA, expecting to pocket the entire account balance. In reality, if your inheritance money is held in a retirement account to which pre-tax dollars were contributed, such as a traditional 401(k) or IRA, federal and state 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 your tax return, which can substantially increase your tax bill and eat into your family inheritance. In contrast, you will 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.

Once you understand your tax obligation for a family inheritance, you can decide when and how to take out the funds to minimize or avoid taxes on inheritance money in a particular year or set of years. For example, 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 in December of this year, and some in January of next year, you can spread the distribution and the tax burden over two tax years.

Another option: 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. This way, you don't feel pressure to cash out inheritance money immediately; rather, 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 70.5 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.

To predict the tax burden of withdrawing assets in inherited accounts of any kind, use tax software or ask a CPA or financial advisor 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 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.

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

Many creditors will attempt to collect debts from family members of a deceased person. 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.

That said, the death of the deceased debtor doesn't automatically clear his debt. 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 will is the key to preserving its value.

Next, determine what the home is worth. You can use an online resource such as Zillow to get an approximate 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.

Does the home have 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, however, the home value less any selling costs (realtor's fees) is worth more than the mortgage, then 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.

If you decide to sell the home, 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.

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.

Buying Dubious Financial Products

There are over 300,000 people in the United States who call themselves financial advisors. The compensation of many of these advisors 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 advisor. These individuals 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 will, therefore, help you decide what to do based on your unique situation and future goals.

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 $11.58 million or higher in 2020.

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.