Table of contents
- Don’t rush. Take time, reflect and make a plan
- Understand and account for taxes
- The difference between heirs and spouses
- Implementing the plan
According to a recent article in Kiplinger’s, the Federal Reserve estimates that the average inheritance is $295,000 and only .3% of heirs receive over one million dollars. There amounts vary quite a bit over the entire US population. Receipt of an inheritance of any amount can be a life changing experience if handled with care. But, unfortunately, 70% of those who receive a bequest blow it within three years according to the National Endowment of Financial Education. We can attest to the high number of inheritances that are frittered away no matter what the amount. How can you ensure that the inheritance you receive is preserved?
Don’t rush. Take time, reflect and make a plan
First, avoid making drastic moves with the money. Take a pre-determined period of time of six months to one year or more and simply decide to NOT make any decisions. Sit with the money in the bank before you decide to quit your job, buy that dream house, or indulge yourself in an expensive car. Use the time to assess and plan. You might want to consult with a fee-only fiduciary financial planner to help coach you through the experience of receiving an inheritance especially if it is a large one. A good planner who is not paid a commission to sell you a product can help you through a variety of issues including investments, insurance coverage, taxes, and retirement. They can help you evaluate your goals and objectives. Once you have taken stock of your new reality you will be better equipped to start making informed rather than emotional decisions.
Understand and account for taxes
Another important facet of the planning phase is to determine how much of your inheritance will be lost to taxes – both inheritance and income taxes. For example, Pennsylvania imposes a 4.5% inheritance tax on assets that pass from parents to children. However, there are thirty-three states that don’t have such a tax, so, you will want to do some research on the state in which you reside. Federal estate taxes are usually not an issue for most now that the estate tax exemption is $11,700,000 per person. But, this number is expected to drop back to five million in 2026 and it is way too early to predict the nations political environment that far out.
There could also be income taxes that need to be paid but it is dependent on the type of asset it is. For example, non-retirement accounts get what’s called a “stepped-up basis” at death. If you inherit stocks worth $500,000 but only $100,000 was originally invested, the $400,000 gain is “stepped-up” so that you don’t have to pay 15% (20% for those in the highest tax bracket) capital gains taxes on the gain. In this case, $60,000 of taxes are saved! Real estate is handled the same way. So, non-retirement assets are very preferable to inherit.
Life insurance proceeds are also received income tax-free but are included for state inheritance tax and federal estate tax purposes. Annuities (a cousin of life insurance) can continue their tax-deferred status but do require a required minimum distribution annually based on life expectancy.
The difference between heirs and spouses
Retirement accounts, however, are treated very differently for heirs, not spouses. Surviving spouses can roll IRA’s and 401(k)’s into their own name and must take an annual required minimum distribution. The problem arises for single people or after the surviving spouse dies. Since January 1, 2020, heirs of retirement accounts must empty these accounts within ten years of death of the account holder. There is no longer an annual required minimum distribution in this scenario. Instead, the heir can choose how to empty the account (year one, year ten, or anything in between) so long as the retirement account is emptied ten years after death. The income tax due is based on the beneficiary’s tax rate. Big problems can arise with large IRA balances going to beneficiaries. The amount that is withdrawn from the inherited retirement account is treated just like ordinary income. So, if you are a high wage earner you could experience over 40% shrinkage of the IRA to taxes – yikes! People who have large IRA account balances may even want to expedite distributions from these accounts if the tax rate is lower than that of the beneficiary.
Implementing the plan
Once you know how much of your inheritance will be left after taxes then you can implement the plan that was pre-determined during the time out/planning phase. You will be in a much better position to know how much of the inheritance you can spend on you and your family and how much should be set aside and invested wisely. Pay special attention to where you place certain asset classes in non-retirement accounts so that you don’t create an unintended tax consequence for yourself. Lastly, don’t forget to re-evaluate your own estate plan and make sure there is enough liability coverage in place to protect against lawsuits.
Receiving an inheritance can be more complex than you realize. But if you take your time, assess, plan, and implement thoughtfully your odds of preserving the money for the future are greatly enhanced.