Inheriting money is akin to a financial windfall. The problem is many people don't know what to do when they come into money.
In fact, 72% of Americans say they lack the confidence to manage a large influx of money, such as an inheritance, on their own, according to a recent survey by Citizens Financial, a bank.
The lack of education with managing inherited wealth comes at a precarious time. Aging baby boomers are set to pass on a massive amount of wealth. Over the next 20 years, $72.6 trillion in assets will be transferred to heirs. And $53 trillion of that total will be passed on by boomers, according to market research firm Cerulli Associates.
"We see a lot of windfall situations these days," said Gaby Mechem, CEO of NIM Retirement Group. In fact, 31% of Americans expect to receive an inheritance within five years, the Citizens survey found.
What's The Game Plan If You Inherit Money?
Making the right moves with inherited wealth involves a fair share of planning, preparation, and giving some thought to things you can do with the money. An inheritance can be a financial game-changer for many households. And identifying goals for the influx of assets — whether it be cash, stocks, IRAs or a house — is a key step in mapping out a revised financial plan.
What people say they'd do with a windfall isn't surprising. Six of 10 said they'd invest the money, according to the Citizens survey. Half said they'd pay off debt. One in three (36%) said they'd buy a new car, 26% said they'd travel the world, and 20% said they'd splurge on a vacation home.
Move Slow
What you don't want to do is rush out and spend every penny. Don't invest hastily, either. Hold off on cashing out of investments before you know the tax ramifications, too.
Take a breath.
"The most important thing is to not make any sudden changes or rash decisions (with the money)," said Mechem. Think before you act. Avoid making major decisions within the first year, such as investing a lump sum or buying a vacation home. First, analyze how the windfall will impact you financially."
"I advise people to slow down," said Jamie Cox, managing partner at Harris Financial Group. "You want to be more thoughtful about claiming assets and making financial decisions. Because the faster you make decisions, the more likely you are to make mistakes."
It makes sense to consult with your financial advisor. And if you don't have an advisor, it's prudent to consider meeting with one.
"It never hurts to have a conversation with a professional to fill in the blanks and check the boxes of things you don't know so that you are able to make informed decisions," said Mechem.
Be Mindful Of Taxes
Inheritances are not considered taxable income. Most of them don't trigger a taxable event with IRS. But subsequent earnings you make on the assets may need to be reported, according to TurboTax. Look out for tax consequences of taking distributions on things like IRAs and annuities, warns Cox. Try not to trigger any unnecessary tax bills.
One of the biggest mistakes inheritors make is "not paying attention to the tax consequences of the various account types" that they inherit, said Cox. "Your windfall on paper is not the same as your windfall after taxes."
For example, you don't want to liquidate a lump sum from an annuity you inherit until you understand the tax rules surrounding distributions. Often, sizable account withdrawals can result in a surge in income that can lead to a big tax bill. IRA withdrawals can do the same.
Different rules apply depending on the type of beneficiary. That might be nonspouse heirs having to withdraw all the assets in an inherited IRA within 10 years of the original IRA owner's death. In that scenario it might be better, for example, to make IRA withdrawals every year. Taking a lump-sum distribution in year 10 could bump you up into a higher tax bracket and result in a bigger tax bill, Cox says.
Cox recalls a client that was receiving child tax credits and other government subsidies who lost those perks because they made a large withdrawal from an inherited IRA to buy boats, cars and other luxury items. The large withdrawal pushed them up to a higher tax bracket. That ended up in a big tax bill as well as a loss of prior tax-friendly benefits.
With some planning, the mess-up could have been avoided, Cox says.
"They could have taken out a little every year and stayed in the same tax bracket and continued to receive those other benefits," said Cox.
Step-Up Cost Basis When Inheriting Money
Some inherited assets are more tax-friendly than others.
Inheritors of stocks or real estate, for example, benefit from a "step-up" in the cost basis of the asset. When the owner of Apple shares or a Victorian home dies, for example, IRS rules allow those assets to receive a new cost basis equal to the value of the asset at the time of death.
So, if the deceased account holder bought Apple shares at $100 many years ago, and due to appreciation the stock is now worth $192 at the time of death, the inheritor will avoid the capital gains on the stock appreciation. The same rule applies for real estate. If a home was purchased for $100,000 and was worth $500,000 at the time of owner's death, the inheritor could sell the home at $500,000 and avoid paying capital gains on the sale.
So, if an inheritor needs to raise cash to pay off debt or come up with a down payment for a home, assets that receive this type of market valuation are a good place to start, says Cox.
What To Do With The Money?
What you do with assets you inherit has a lot to do with your personal financial situation, says Cox. If you're financially well off and don't need the extra money, incorporate the influx of assets into your existing financial plan. But you should do it in the most tax-efficient manner.
On the other hand, if you have little or no savings, and are mired in debt, pay off your bills in full. Then educate yourself on personal finance basics so you don't get into debt again. Use the inheritance money as a building block to a better financial future that includes funding an emergency fund as well as college and retirement savings accounts.
Most people, though, fall somewhere in the middle. We're talking about people who still owe money on their mortgage and have 401(k)s and 529 savings accounts but could benefit from adding to their account balances.
"An inheritance is a great way for most people to accelerate their own personal savings or make up a small savings gap that may exist in their retirement account," said Cox.
Take A Bucket Approach When Inheriting Money
Don't spend it all. Don't invest it all. And like any financial plan, divvy up the money into different buckets, or what Mechem dubs "bands of money."
"Before you make any decisions or go spend, there needs to be a financial plan that takes different time horizons into account," said Mechem.
Mechem recommends splitting the money up into a number of buckets. There's nothing wrong with spending some of the money to "experience the inheritance," says Mechem. "Maybe go on a trip and remember your loved ones in the right way," Mechem said.
Also fill in any holes in your short-term bucket. That might mean boosting your savings and funding an emergency fund. You might also dig out of debt. "Some families have more urgent issues than others," said Mechem. "Do you have credit-card debt at 29%? If so, maybe paying that off is the number-one thing you need to do."
Address any other midrange goals, too. Perhaps set aside cash for college tuition or a down payment to buy a home. And, finally, address any long-term financial issues, such as building up your retirement account.
The key after receiving an inheritance is to identify your financial goals, says Mechem.
And, of course, avoid making mistakes that can't be undone. Don't blow through the money in a few weeks using it to buy depreciating assets like boats, cars and RVs, says Mechem. "These things are very high in price but over time will depreciate, versus building up or protecting your nest egg," said Mechem.
