What to Consider When Receiving an Inheritance
presented by Doble LeBranti Financial Group
It is sometimes said that an inheritance is both a blessing and a curse—a blessing because it may provide you with financial resources that can help you to achieve goals that you were previously unable to achieve, and a curse because it usually means that a loved one has died.
Whatever your circumstances are, it is important to manage your inheritance well. We have compiled a list of some important considerations as you begin to plan your next steps.
Take time to grieve
You have likely just lost a loved one, so at this point we recommend taking a deep breath. You want to give yourself a chance to grieve without having to dive right into making important financial decisions. Take a moment, or even a few months, and let the dust settle and regain your equilibrium before making any big decisions about buying or selling assets. Once you feel more balanced, you will be in a better place to make lasting, meaningful decisions.
Beware of scammers
If you are grieving the loss of a loved one and have recently inherited assets, you have unfortunately just become a target for scammers. Make a point of avoiding anyone who aggressively pushes you to take action. There is no need to hurry into any decisions right away. There will be good investment opportunities down the road when you are ready, so be on the alert and protect your assets during this time when you may be feeling vulnerable.
Don’t quit your day job
While you may be tempted to look at your recent inheritance as a reason to stop working and consider an early retirement, this is rarely a wise course of action. In most cases an inheritance may provide the opportunity for a lifestyle change but does not provide enough assets to rule out the need for current income. It is easy to underestimate the amount of money you will need for retirement, and the earlier you retire, the more years you will spend in retirement. Take your time and make sure you have a sound financial plan before making any significant changes to your employment.
Identify goals and prioritize
What are the goals that were important to you before you received your inheritance? Have they changed? Perhaps your top priorities were to pay off your home and send your children to college, but now that your finances have changed, you might be asking yourself what you can buy or give away. Carefully consider whether your goals have changed. To avoid regrets, try reframing your question to something like, “What can I accomplish now that I couldn’t before?”
Be prepared to say no to family and friends
You will likely find family members and friends offering advice to you about what to do with your inheritance. While many of these people are well-intentioned, it is important for you to set boundaries as early as possible. Some investments may sound like a good idea, such as funding a grandchild’s 529 account or paying off an adult child’s mortgage, but might not be the best choice for your situation. Before you make any commitments to friends or family, meet with a financial advisor to make sure that you are financially secure before you commit to helping others.
Honor their legacy
When you are thinking about what to do with your inheritance, it can be helpful to remember where the money came from. Think about the hard work that went into earning and accumulating those assets and keep that in mind as you formulate your intentions. This is a person’s legacy that has been intentionally passed to you and being mindful of that helps lead to more responsible, thoughtful decision-making.
What to consider with different types of inherited assets
With real estate, the most important thing you want to keep in mind is the step up in cost basis available to you when you inherit a property. Let us say your great-aunt bought a house for $200,000 which appreciated in value and is worth $1,500,000 at the time of her death. When you inherit the property from your great-aunt, your cost basis is the fair market value of the property on the date of death, or $1,500,000. Whenever you ultimately decide to sell the property, your cost basis will be $1,500,000 and you will not be responsible for paying capital gains taxes on the $1,300,000 of appreciation before you inherited. You can avoid an unnecessary and significant tax bill if this is handled properly. In this case it is advisable to get the real estate appraised in case the IRS comes knocking.
Much like real estate, inherited securities also benefit from a step-up in cost basis. The cost basis of any securities you inherit are reset to the market value on the date of the original owner’s death. This allows you to inherit these assets virtually tax-free. It is important to keep accurate records of any securities you inherit and your new cost basis for future tax reporting purposes. This is where we often see tax planning mistakes. Inherited securities may not have any recorded cost basis and one may have to hire someone to figure out what it should be, or in some cases, make assumptions. Oftentimes we see people paying big capital gains taxes for no reason by forgetting to step up their basis in a stock or mutual fund. As an example, your mom purchased AT&T Stock back in 1980 for $10,000 and started an auto investment plan of $25/month. She passed away in 2020 and you inherited the stock with a cost basis of $50,000, but a value of $250,000. Upon receiving the asset through probate, you sell it immediately, generating a $200,000 gain, costing you $50,000 in capital gains taxes. You could have received a step-up to AT&Ts current value of $250,000 and owed $0 in capital gains tax. This is a simple tax saving strategy that can add up quickly if applied across an entire estate.
When inheriting an IRA or other qualified retirement plan, the rules are different for spouses versus non-spouses. As a spouse you have the option of transferring the money to your own retirement account. Once the transfer is complete, rules for distribution are the same as if the account had always been yours.
The other option is available to both spouses and non-spouses. You can transfer the money to an Inherited IRA, otherwise known as an IRA Beneficiary Distribution Account, or IRA BDA. The money in the Inherited IRA will continue to grow tax-deferred, and you can generally withdraw the money at any time without penalty. Inherited IRAs are subject to Required Minimum Distributions (RMDs) which in most cases require that all the assets be withdrawn within ten years of the original account owner’s date of death. The timing of these distributions can have an impact on your tax bracket, so take this into consideration when determining the timing of your withdrawals.
Your inheritance may put you in a better position to make a donation to a charity that is dear to you. This may be either a one-time donation, or, if you are looking to combine charitable giving with reducing your taxes as part of your overall financial plan, you might consider a Charitable Remainder Trust, or CRT. This type of trust is a tax-exempt irrevocable trust that first disperses income to the beneficiaries of the trust for a specified period of time, and then donates the remainder of the trust to the designated charity. In this way, you can enjoy income from the trust during your lifetime, and then upon your death, the charity receives the remaining assets in the trust. There are other tax-advantaged vehicles for charitable giving as well, so talk to a financial professional to determine which type might be best for your situation.
Insurance and estate planning needs
It is always a good idea to periodically review your insurance coverage as well as your will and any other estate documents. Receiving an inheritance may change the type and amount of insurance coverage you need. If you hold life insurance, one consideration is whether to hold your life insurance policy in an Irrevocable Life Insurance Trust, which would keep the proceeds of your policy out of your estate upon your death. The benefit of this is that it keeps the proceeds out of probate, which would allow immediate access to the funds by your heirs, and also protects the proceeds from the claims of your probate creditors. If you haven’t previously drafted estate documents, now might be a good time to talk to an estate attorney to review any other considerations that might benefit your individual situation.
Estate Taxes are due nine months after the decedent’s death, so there is some time to grieve and go through your process. If the estate is heavily invested in illiquid assets, like real estate, it’s a good idea to do some back of the napkin calculations to figure out if there is liquid cash to pay for the estate taxes that will be due, otherwise, selling real estate at the wrong time could be detrimental to one’s long-term wealth plan.
This advice is intended to be general in nature. As with any financial strategy, please do your own due diligence and talk with your advisor, CPA and estate attorney to determine what strategy works best for you.