Avoid These Inheritance Money Tax Traps

Don't Be Caught off Guard by Inheritance Taxes

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Getting a family inheritance can come with mixed feelings. While you're getting money, you're losing a loved one who cared enough about you to include you in their will. Because getting an inheritance can come with such a flood of emotions, it can also lead to costly mistakes. When you find out that you're receiving money from a will, take some time to plan ahead and protect your money by not making these tax mistakes.

Key Takeaways

  • The tax you have to pay on an inheritance depends on the type of asset, the account in which it was held, and when you choose to receive your payout.
  • Money taken from an inherited 401(k) or traditional IRA is taxable, but you can leave these accounts as-is or roll them over to an ​inherited IRA.
  • The basis of inherited investments is often stepped up to the value on the deceased person's date of death, so you will owe less, or likely nothing, in capital gains tax.
  • To reduce or avoid the estate tax, you can use the alternate valuation date to result in a lower value at the time of sale.

Trap 1: Cashing In Before Figuring Out Inheritance Tax

Before you seek a payout of the money you inherited, figure out whether you will have to pay taxes and, if so, how much you will have to pay. The amount you will pay in tax on inherited money depends on the type of asset that was passed down to you, the account in which it was held, and when you choose to receive your payout.

Taxes on Inherited Retirement Accounts

Some people who don't know any better take the cash from an inherited retirement account, expecting to pocket the entire account balance. If your inherited money comes from a retirement account to which pre-tax dollars were contributed, state and federal income tax on the money has not yet been paid. Examples include a 401(k) or individual retirement account (IRA).

If you withdraw money from one of these inherited accounts, the amount must be added as taxable income on your tax return. This could increase your tax bill by a lot, and you could end up with less money. In contrast, you can avoid paying inheritance tax when you take a payout from an account funded with post-tax dollars, such as a Roth 401(k) or Roth IRA.

You may have a hefty tax bill if you take the entire amount of an inherited retirement account in a single year, but if you withdraw some this year and some early next year, you can spread the tax burden over two tax years.

You can leave a traditional 401(k) or a Roth 401(k) you inherit as-is or roll it over to an ​inherited IRA account. By making this move, you won't feel the pressure to cash out inheritance money right away. Instead, you only have to take out a required minimum distribution each year, which is the least amount you have to withdraw from retirement accounts after reaching 72 years of age. In many cases, this approach will allow you to divide the income and taxes on your inheritance over the rest of your life and avoid paying high taxes on inherited 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 not the same. 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. The amount will depend 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 taking assets out of inherited accounts, use tax software or ask a CPA or financial adviser to conduct a tax projection. That can give you a notion of what you will pay in taxes this year based on account statements and other documents.

Taxes on Life Insurance Proceeds

The good news: If you receive life insurance proceeds as a beneficiary of someone who died, this amount is almost always tax-free. You will not have to report these payouts as taxable income on your tax return. Keep in mind that the interest you receive on the proceeds is taxable income.

Trap 2: 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 don't have to pay the debts of someone from whom you receive an inheritance.

Debts are not automatically cleared when someone dies. If the estate has the money to pay off the debt, it generally must do so. That can reduce the inheritance of the heirs by a little or a lot.

The proceeds from a life insurance policy generally aren't taxable, but the interest is.

Trap 3: Not Looking at All Options When You Inherit a Home

When you inherit a house, the first thing you should do is secure and maintain it 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 the home and look after it if you can't? Maintaining the home while you decide what to do with it is the first step in keeping its value. Other factors come into play when deciding what to do with an inherited home.

  1. Find out what the home is worth. You can use a website such as Zillow to get an estimate of the home's value. Just keep in mind that online sites may not have up-to-date data on the property. A realtor who knows the area will be your best resource.
  2. Find out whether the home has a mortgage on it. If there is a mortgage, but the home is worth less than the amount still owed on it, you may decide that the best course of action is to stop making the mortgage payments and let it go into foreclosure. If the home's value minus selling costs is more than the mortgage, you will need to make sure the payments are made while you prepare the home for sale. If you do not make the mortgage payments, the lender has the right to foreclose on the home.
  3. Consider selling the home. If you decide to sell the home, you'll need to figure out your tax burden. When you inherit a home, the value of the home on the deceased's date of death becomes the cost basis for tax purposes. If the house is worth $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. 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. A good tax preparer can help you figure out these details.
  4. Decide whether renting out the home is an option. If you can't take on the tax burden of a property sale, you may be able to rent out the home. As an investment property, it may provide more financial benefits to you than what you could achieve if you were to sell it and invest the proceeds.
  5. Live in the home. If the home suits you more than the one you live in now, 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 was owned free and clear when you inherited it, you'll need to have a title search done, transfer the title to your name, and pay fees for having that done. You'll also take on the costs for upkeep, taxes, homeowners association fees, and any other costs that come with owning a home.

If you're lucky enough to inherit a nice piece of property, you don't have to sell it. If the property would be a great fit for you or would make a great second home, talk to an accountant or lawyer to see whether there's a way for you to keep it.

Trap 4: Buying Shady Financial Products

There are over 200,000 personal financial advisers in the U.S. The money these advisers earn depends on selling investment or insurance products. Upon finding out that you have inherited money and are not sure what to do with it, some shady dealers might try to sell you on a poor investment that could cost you a large portion of your inheritance.

For this reason, you shouldn't invest in or buy insurance products without going through a complete financial planning process. If you know that you are soon to receive an inheritance, start your search for a fee-only advisor. These people get paid to advise and help their clients plan for their financial futures. They have a responsibility to work in their clients' best interests. You should expect to get honest help as you decide what to do with your money based on your current situation and future goals.

Look for a financial planner who charges a fee rather than one who makes a commission by selling you certain financial products.

Trap 5: Not Knowing About the Alternate Valuation Date

An estate will generally be subject to federal estate tax if its value 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 allowed 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. This method may help you reduce or avoid taxes on the estate and preserve more of your inheritance.