With an inheritance come a variety of potential outcomes, both good and bad. When one manages a sizable inheritance prudently, it can represent a life-changing opportunity. Without an understanding, however, of the possible financial pitfalls that surround receiving an inheritance, you may find yourself in the center of a financial minefield. The following tips will help you make the most of an inheritance.
Take your time.
An inheritance is frequently related to the loss of a loved one. This emotional time is not the best one to be making important financial decisions. Short of meeting any required tax or legal deadlines, avoid hasty decisions concerning your inheritance. Try to maintain your current budget and lifestyle until you’re in a better position to make financial decisions.
Identify a team of reputable, trusted advisors.
You need an attorney, accountant, and financial/insurance advisors you can count on. There are complicated tax laws and requirements related to certain inherited assets. Without accurate, reliable advice, you may find an unnecessarily large chunk of your inheritance going to pay taxes. In addition, you may benefit from a review of your overall financial situation in light of your inheritance.
Park the money.
Deposit the money or investments in a bank or brokerage account until you’re in a position to make definitive decisions on what you want to do with your inheritance. If you’re married, you will need to decide whether to establish the account is in your name alone or jointly with your spouse. Inherited assets have special protection in the event of a divorce. If you commingle inherited assets in a joint account, however, you run the risk of losing that special protection.
Understand the tax consequences of inherited assets.
If your inheritance is from a spouse, there may be no estate or inheritance taxes due. Otherwise, your inheritance may be subject to federal estate tax or state inheritance tax. Income taxes are also a consideration. Life insurance proceeds are generally free of income tax. Non-retirement assets receive what we call a “step-up” in cost basis. That means that if you later sell these assets, any capital gains tax you owe on asset appreciation will be based on the asset’s fair market value at the date of death (or at the alternative valuation date), instead of being based on what the deceased originally paid for the asset. Inherited retirement plan assets are subject to income tax when you receive them from the plan.
Treat inherited retirement assets with care.
The tax treatment of inherited retirement assets is a complex subject. You’ll find a variety of options available, but they come with deadlines and vary according to the type of retirement plan and your relationship to the deceased. Make sure the retirement plan administrator does not send you a check for the plan proceeds until after you make a distribution decision. Get sound professional financial and tax advice before taking any money from an inherited retirement plan…otherwise you may find yourself liable for paying income taxes on the entire value of the retirement account.
Develop a financial plan.
Consider working with a financial advisor to “test drive” various scenarios and determine how your funds should be invested to accomplish your financial goals. The “step-up” in cost basis received by non-retirement plan inherited assets may make it attractive from a tax standpoint to sell those assets before selling other appreciated assets in order to rebalance your portfolio. Try not to let emotions guide your investment decisions…just because a particular investment was owned by the deceased doesn’t mean that investment is the best choice for you in your situation today.
Review your estate plan.
Your inheritance, together with your experience in managing it, may lead you to make changes in your estate plan. For example, the inheritance may increase the size of your estate to an extent that it will be subject to estate taxes. You may decide that you’re now in a better position to plan for lifetime or testamentary charitable giving (or both). You may want to implement a program of planned lifetime giving to children and/or grandchildren. Your experience in receiving an inheritance may prompt you to want to do a better job of how your estate is structured and administered for the benefit of your heirs.