When it comes to inheritance, it's typically more gratifying to think about how to spend the newfound money than what the tax consequences might be. But earning a payout from a deceased relative comes with its own complicated tax repercussions. And spending the gifted money too quickly or thoughtlessly could result in an unexpectedly high tax bill.
So how can heirs ensure that they're thinking about taxes when benefiting from an inheritance? Here's what to know about tax-savvy ways to manage inherited wealth.
Inheriting IRAs or 401(k)s. If a deceased relative, spouse or friend passes along an individual retirement account or employer retirement savings account, it's important to note how it will be taxed.
Your options for the account depend on your relationship to the deceased person. A spouse may be able to roll the funds into their own account, an option other beneficiaries don't have. Alternatively, a spouse can open an Inherited or Beneficiary IRA account, which carries both partners' names and from which a young spouse can withdraw funds without triggering the 10 percent early withdrawal penalty.
Heirs who are not the spouse of the benefactor -- for example, a child, nephew, niece or grandchild -- don't have the option to place the money into their own retirement account but can hold it in an Inherited IRA account.
Once they decide how to house the money, the speed with which spouses and other heirs decide to withdraw the funds can have big tax implications. If they decide to take out all the money in a lump sum, they may get hit with a "double whammy" tax bill, says Tatyana Bunich, founder and president of Financial 1 Wealth Management Group in Columbia, Maryland. Here's why: For a traditional IRA, the lump sum would be treated as taxable income -- beneficiaries could pay about 40 percent in taxes if they live in a state that charges income tax -- plus it could push them into a higher tax bracket, causing them to pay more taxes on regular income.
If you need the money right away, this may be your only option. But Bunich advises setting aside at least 40 percent of that lump sum, if it's a large payout and you live in a state with income taxes, for your tax bill, so you don't end up unable to pay your taxes the following April.
The more tax-savvy move for heirs to make would be to spread out the distributions over their lifetime instead of taking a lump sum. This strategy is sometimes referred to as a "stretch IRA" because it allows investors to stretch out the time during which earnings can grow.
While the exact rules for how beneficiaries manage Inherited IRAs will be determined by whether the deceased person was older than 70 1/2 at the time of death, generally heirs who want to keep their tax bill as low possible must take required minimum distributions, commonly called RMDs, based on their life expectancy within about a year of inheriting the account. They won't be hit with the 10 percent early withdrawal penalty, but they'll be taxed on the amount withdrawn. Still, the required distributions will generally be smaller than a lump sum and less likely to knock them into a higher tax bracket.
It's important that recipients who want to take minimum distributions take the first one before the required date or they risk being forced to liquidate the account within five years, says Chris D. Hardy, a certified financial planner, enrolled agent and director of planning and investments at Paramount Investment Advisors in Suwanee, Georgia.
Keep in mind that inherited Roth IRAs have already been taxed and do not carry the same tax burden. But don't let that convince you to immediately withdraw a lump sum. "A lot of folks think, 'There's no taxes on it at all, so I'm going to pull the whole thing out,'" Hardy says. "At the end of the day, as long as you take RMDs out, funds can stay in account and grow tax-free."
Inheriting stocks or mutual funds. A relative may choose to pass on investments that were housed outside of a retirement account, such as individual stocks or mutual funds.
The key to reducing any taxes on the sale of these investments is to remember what's called a "step-up basis," experts say. "When your benefactor dies, no matter what they paid for that stock or mutual fund, the cost basis 'steps up' to whatever the price of that stock or fund was at the date of death," says Dennis Nolte, certified financial planner and vice president at Seacoast Investment Services in Winter Park, Florida.
So, say, your grandfather purchased Disney stock for $5 per share, and when he dies, it's worth $100. The heir's basis is what the value was when Grandpa died, not the price at which Grandpa bought the stock decades earlier.
That can make an important difference when it comes to how heirs calculate and pay capital gains taxes upon the sale of an asset.
Take note that these assets may have to go through probate, Bunich says. Probate is a legal process and the way an estate is settled. Assets such as mutual funds and houses that do not have a beneficiary designated may go through probate, Bunich says. "It is a very time-consuming, costly process that can only be avoided if proper planning was done in advance," she says. "At that point, there's nothing [to do] but work with a good attorney."
Inheriting a house. Like with stocks and mutual funds, an inherited house enjoys a step-up basis, meaning that, for tax purposes, the cost basis is what the market value was when benefactor died.
Experts recommend getting the home appraised soon after the benefactor's death in order to gain an understanding of what the basis is now. If it's not being passed along to a spouse, an inherited house will typically have to go through probate, Bunich says.
Inheriting life insurance. Good news for heirs on this one. "Life insurance is kind of awesome because it's tax-free," Bunich says. But remember, Nolte says, that just because it's tax-free doesn't mean you shouldn't do good financial planning when deciding where to stash the life insurance payout, how to spend it and where to invest it.
Inheriting cash. A cash inheritance is not taxable at the federal level, Bunich says.
In general, receiving an inheritance may ultimately be the life change that causes you to finally start seeing a financial advisor, tax planner or estate planning attorney. Getting strong advice could help you use the money most effectively and avoid a large tax bill.
Find somebody who will take a more advisory and educational role, not someone who's there to sell you products, Hardy says. And remember that receiving an inheritance can transform your financial life for the better if you manage it wisely. "It's a great time for somebody to hit the pause button to say, 'I need to know what my goals and objectives are," Hardy says. "It's just a really good time to take a deep breath, sit back and dream and see what the money can do."
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