Before you start making plans, make sure you know how the inheritance can affect your existing financial situation, including your taxes and other financial planning areas. A good place to start is to understand some common sources of inheritance, which we will discuss in this article.
Checking/savings: If you inherit assets that were held in a checking or savings account, you will not need to sell anything to receive the funds. There is no tax liability; you receive the amount in cash.
Investment account: An investment account is a taxable account invested in holdings like stocks, bonds and mutual funds. These holdings move into your name upon inheriting them. There is no need to worry about the fact that Aunt Sally started investing in these holdings back in the 80’s when the cost was a fraction of what it is today. At the inheritance, you will receive a stepped-up cost basis based on the date of death valuation. You may choose to sell all or a portion immediately and your taxes on the sell will most likely be minimal. Keeping the holdings and allowing them to continue to grow may be an option for you, just keep in mind any dividends, interest, or capital gains paid out each year will be reportable when you file your taxes. Be mindful of the realized gain or loss amount as you sell, you do not want to be surprised at tax time if you have large capital gains to report.
IRA: If you have a basic understanding of an IRA, you know that this type of account allows the owner to grow the assets within the account tax-free. When withdrawn it is reported as ordinary income. For an inherited IRA this holds true, but instead of waiting until age 72 for your first mandatory withdrawal you must deplete the account within 10 years of inheriting the IRA. You can take out an equal amount each year or let the account grow and take it out all in the 10th year. We recommend working with a financial advisor or CPA to determine the right schedule for you. Remember, the amount you take out of the account is reportable as ordinary income and will be taxed at the income level you fall into for that tax filing year. Be careful because the more you withdraw, the more income you have to report and potentially pay taxes on. You could also unknowingly push yourself into a higher tax bracket, which effects not only your inherited withdrawals but the tax rate on your own earned income as well.
Roth IRA: All original funds in the Roth IRA were taxed before the original owner added to the account, allowing the funds to grow tax-free along with tax-free distributions. This benefit rolls over to you, the heir, making it a very attractive type of account to receive. This account will not affect your tax situation or increase your reportable income as long as you follow the rules, which requires you to take the money out within 10 years of inheriting the account. In the case of a Roth if you do not need the funds, it may make sense to let this account grow tax free and withdraw the funds in year 10.
Life Insurance: Typically, the proceeds you receive as a beneficiary on a life insurance policy are not taxable and the proceeds will not change your tax situation.
Real assets: A few common real assets that we often see passed on are homes, land, vehicles, furniture, collectables, and jewelry. If you inherit any type of real estate and choose to keep it, you will become liable for property taxes, insurance, upkeep, and any other costs associated with the property. A car or any other type of transportation will also require you to retitle in your own name, thus making you liable for the taxes, insurance, and any other costs. From a financial standpoint, there is typically not much concern over a piece of furniture, jewelry, or collectables unless you are looking at high dollar items that require maintenance, storage, insurance, etc.
Now that you have an idea of some common sources of inheritances and how it affects your tax situation, let’s look at some other areas of financial planning that are important to review if you have received a significant amount of money.
Emergency fund: Everyone should have an emergency fund. If you don’t, this is a great opportunity to put away cash for the unexpected. Depending on your situation this could be anywhere from 3 months of living expenses to 1 year or more.
Debt: If you have any amount of debt this is a good time to considering paying it off or at least paying it down depending on the interest rate. A good rule of thumb is to start with the debt that has the highest interest rate.
Investments: If you receive cash or investment assets, there is no reason you cannot choose to keep it invested. Taking the time to assess your current needs, then mid to long-term goals will help guide the way you invest and determine what may be appropriate for you.
Retirement: While you can’t take all the money and put it all in a retirement account right away (there are annual maximums) you can still contribute up to the annual maximum in your own retirement account (an IRA or Roth) as long as you are eligible to contribute.
Insurance: With your increased net worth you will want to review your liability coverage. An umbrella policy is very inexpensive compared to the coverage that you receive and can protect your assets in the event of a liability claim. The amount of assets you receive may also change your life insurance needs and other personal insurance policy needs.
Planning: Whether you have already started your own estate planning, now is a great time to start or review what you already have established. Work with your financial advisor and/or attorney to determine what may be appropriate for your situation. Whether it be a simple will and power of attorney documents, or more complex like establishing a trust, getting it done will give you great piece of mind.
Inheriting assets is always a bittersweet situation and, if you find yourself here, we hope you choose to use it as a tool to set yourself up for long-term financial success. If you inherit assets, call your financial advisor so they can help to create a plan that is right for you.
*For this article, we assume the deceased’s estate is no larger than $11.58 million (2020 estate and gift tax exemption limit) to avoid confusion over estate tax. We also assume the assets have already been though probate or the person inheriting assets was named directly as a beneficiary on an account, and assets were not held in trust.