Don’t Let a Relative’s Financial Irresponsibility Ruin Your Inheritance

The passing of a friend or relative is emotionally taxing, but the possibility losing an inheritance to the deceased’s outstanding debt can create just as much financial distress in the midst of the loss.

Depending on a state’s inheritance laws, some beneficiaries may be held liable for repaying debts back to their respective creditors, either through the value of assets they have received from a relative passed-on or from their own wallet.

Understanding how inheritances work and how inheritance tax requirements are assessed can help you retain as much of your inheritance as is legally possible.

What is an Inheritance?

An inheritance is any asset passed on from one individual to another person or organization. When a person dies, the deceased can plan in advance how he or she would like to divide the estate (this can include items like jewelry, property or money).

To make this allocation biding upon a person’s death, a legal document commonly referred to as a will is drafted to legitimize the passing of ownership of the assets. Recipients of an inheritance are typically contacted by a third-party individual like a lawyer or by an identified executor of the will who can either be court appointed or a trusted family member or friend.

Whatever asset is stated on the written will shall be granted to the receiver, unless other circumstances — like outstanding debt — arise which can hinder the full inheritance from being forwarded to its new owner.

Can a Relative’s Outstanding Debt Affect an Inheritance?

You may be shocked to find that even while still grieving after losing a friend or relative, creditors may be in their legal right to collect outstanding debts from the estate, even if it’s at the cost of your inheritance.

A survey conducted by CESI Debt Solutions revealed that almost 40 percent of all seniors have accumulated some level of debt in their golden years, but do not have an established plan for paying it back within their lifetime.

Before inheritances are doled out to their respective heirs, it’s the executor’s responsibility to ensure that any existing debts owed by the deceased are attended to first. For this reason, any amount of reckless debt accumulated by the deceased will first be paid off from estate assets, like savings accounts, for example. It’s only after these debts have been settled that the remaining savings account funds will go to their legal heir.

Additionally, estates do not escape the watchful eye of Uncle Sam. Federal taxes are also paid through the estate before recipients of inheritances get their share.

Estate Tax

The estate tax is sometimes confused with inheritance laws imposed by some states. Currently, the federal estate tax exemption is set at $5,120,000, so any estate with a gross value that falls below this figure may not be required to file IRS Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return.

Should the estate’s gross valuation exceed the exemption amount, the current estate tax rate of 35 percent will apply.

Inheritance Tax

Certain states require that individual heirs pay an additional inheritance tax on top of the federal estate tax their inheritance may have encountered. Inheritance laws vary by state, but to date, only seven states tax heirs on their gained inheritance: Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.

Each state differs in their tax rate thresholds, with states like Indiana who has the widest tax rate range at 1 percent to 20 percent versus fixed-rate states like Maryland which is a static 10 percent tax rate.

Related: The Top Five Most Unusual Inheritances

Inheritance Laws: Co-Signed Debt

Another type of debt you can still be responsible for as an heir is if you helped the deceased obtain a line of credit by co-signing a loan. If you decided to help a relative out by acting as the guarantor of the loan, your good deed will quickly turn into your debt under inheritance laws.

Since you are also named on the loan, the outstanding balance owed must be paid back to the creditor by the surviving individual. For example, should you co-sign an auto loan for a family friend, upon their death you’ll have to repay the loan.

Those who inherit these kinds of debts from friends and family can choose to sell the item and use those funds to pay back the lender, but if the sale is not enough to cover the entire remaining balance (for instance, a home with an underwater mortgage), co-signers are responsible for paying the debt out-of-pocket.

Is Your Inheritance Safe?

The specifics vary based on the circumstances surrounding each inheritance, as there are a handful of variables and state inheritance laws that come into play when dealing with estates, outstanding debts and inheritance taxes.

If the deceased’s remaining estate is of no value, and a $1,000 credit card balance with only their name tied to it is still due upon their death, most creditors will write off the small balance. Appropriate documentation, however, will be needed, such as a copy of the certificate of death and a formal letter from the executor explaining the situation.

The best course of action when dealing with the questionable fate of an inheritance is to have an open conversation with family, in the likely event that a relative will pass soon. Determine how much outstanding debt has amassed and the financial resources available to the estate, then speak to a lawyer to have a game plan ready.