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Family Inheritance? Avoid These Tax Traps!

Don't Let Tax on Inheritance Catch You Off Guard

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Inheritance tax traps can be avoided by understanding the rules.

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Receiving a family inheritance can be great! It can also be a time where big mistakes can be made. Do the most with what you get by avoiding these inheritance mistakes that others have made.

Mistake 1: Being Clueless About Taxes on Accounts You are Inheriting

Before you cash in an inheritance, make sure you understand if you will have to pay taxes, and about how much. A summary of the most common inheritance tax traps are listed below.

Taxes on Inherited IRA/401k Plans
One of the biggest mistakes people make when they inherit a retirement account is not exploring all their options before cashing it in. Most retirement accounts have not been taxed yet, so when you cash in this type of account the amount you withdraw is included on your tax return as taxable income.

Once you understand this you can decide when and how to take out the money so you pay the least amount in taxes. For example, you could withdraw some in December, and some in January to spread the distribution over two different tax years.

Another option: most plans allow you to roll the account over to an inherited IRA account so that you only have to take what are called required minimum distributions each year. This can allow you to stretch the income and taxes on your inheritance over a long period of time.

Taxes on Inherited Mutual Funds/Stocks Not in Retirement Accounts
For mutual funds or stocks that are not owned in retirement accounts or IRAs, the tax rules are different. Your value on these assets for tax purposes will be the value on the deceased person's date of death. From that point, you will either have a gain or a loss depending on the value of the asset when you sell it.

To estimate the taxes on cashing in inherited accounts of any kind, you can do a tax projection that shows you about what you will pay if you do or do not cash something in. Even better, do multiple year tax planning so you can see how to pay less on what you withdraw.

Taxes on Life Insurance Proceeds
The good news: if you receive life insurance proceeds this amount is almost always tax free. You will not have to report life insurance payouts received as taxable income on your tax return.

Learn more: What Happens to Life Insurance When the Insured Dies?

Mistake 2: Don't Get Tricked Into Paying Debts You Don't Owe

Many creditors will make attempts to collect debts from family members of a deceased person. These claims should be made against the estate, not against you personally. You are not personally responsible for the debts of someone from whom you receive an inheritance. Regard any such demands with skepticism.

Learn more: Who Pays Off a Deceased Person's Debts?

Mistake 3: Not Evaluating All Options When You Inherit a Home

Secure and Maintain
When you inherit a house your primary concern should be figuring out how 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 stay in the home? Maintaining the home will be important to protect its value.

Estimate 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 the home is worth less than the remaining mortgage amount, you may decide the best course of action is to let the house go to foreclosure, in which case you would not continue making the mortgage payments. If the home value less any selling costs (realtor's fees) is worth more than the mortgage, then maintain the mortgage payments while you are preparing the property for sale. If you do not maintain the mortgage payments, the lender has the right to foreclose on the property.

Consider Taxes and Income Potential
What about taxes? When you inherit a home, the value of the home on the decedent's date of death becomes the cost basis for tax purposes. So if the house was worth approximately $100,000 and you sold it eight months later for $110,000 you may have $10,000 of capital gains to report on your tax return. I say "may have" because you might be able to exclude up to $250,000 of gain if the deceased lived in the home for at least two of the last five years. If there is a loss on the sale, you will not be able to use it as a deduction.

You may also wish to consider renting out the home. Perhaps as an investment property it will provide more benefit to you than what you could achieve if you sold it and invested the proceeds. Read 3 Things to Consider Before You Buy Rental Propertyfor some great tips on how to evaluate this.

Mistake 4: Don't Get Talked Into Buying Financial Products

There are over 350,000 people who call themselves financial advisors in the United States. Over 90% of them make their living selling investment or insurance products. Some of these people are like vultures and upon finding out you have money and are not sure what to do with it, they will present you with an investment that they are sure is right for you.

Do not invest or buy insurance products without going through a comprehensive financial planning process. If you know you are going to receive an inheritance this might be the perfect time to start your search for a planning oriented financial advisor who can help you decide what to do based on your situation and your future goals.

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