Heir Economics

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Heir Economics
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
Updated February 26, 2009

Receiving an inheritance can be a life-changing event for some, but for most heirs the money will not likely be enough meet their retirement needs entirely. If you are one of the few who does receive a meaningful inheritance, you'll want to manage it wisely.

Of course, receiving an inheritance can cause mixed emotions. While it's certainly better to be left worrying about what to do with the assets left to you, vs. how to pay off the debts of the dearly departed, dealing with financial matters is probably the last thing on your mind during a time when you're trying to cope with the loss of a loved one. So, it's usually a good idea to just do nothing for a while. There's no rush. Park the money in a relatively safe place, like a money market fund, until you're ready.

Don't worry (too much) about taxes
The decedent's estate is responsible for federal estate taxes. As an heir, you owe no additional federal estate tax or income tax on property you inherit, including life insurance proceeds (though a handful of states still impose some form of inheritance tax, so check with your state). Heirs also receive a step-up in basis (i.e., cost basis is adjusted to equal the fair market value on date of death) on inherited property (e.g., stocks, bonds, mutual funds and real estate). What's more, property you inherit receives long-term holding period status, regardless of how long it was held by the original owner. So nothing should stop you from selling inherited stocks, bonds, mutual funds or other property that does not fit your own investment plan. Don't let emotional attachments keep you from diversifying appropriately.

Consider a financial plan
If the inheritance is large enough to significantly change your financial status, you should seriously consider a professional, comprehensive review of your finances. Even if you've had a financial plan done in the past, any major change calls for a redo. Things to consider:

Changes in tax status. Depending on how big your inheritance is and how you invest it, your income tax status might change. For example, even though municipal bonds didn't make sense for you before because of your tax bracket, the taxable interest generated from investing a sizable chunk in taxable bonds might be enough to push you into a higher bracket where munis make sense. Likewise, your own estate and gift tax status might change as a result of your inheritance.
Net worth structure. Weigh the pros and cons of paying off debt (including mortgage debt) that you may no longer need.
Cash flow. The level of your portfolio income (interest and dividends) may increase as a result of your inheritance, providing an additional source of income. Before you adjust the level of your expenditures accordingly, sit down and create a detailed budget showing all sources of income and all categories of expenses—both non-discretionary (e.g., essential items such as food, utilities and taxes) and discretionary ("fun stuff").
Insurance. Consider whether you still need life insurance for income-replacement purposes. With your newfound wealth, you might also be more comfortable with higher property/casualty deductibles. On the other hand, you may want to increase your personal liability insurance.
Estate planning. A change in net worth could mean your own estate plan needs an overhaul. Be sure you have basic wills and durable powers of attorney and health care in place, and consider the potential benefits of a revocable living trust. In the course of receiving your inheritance, you may have been involved in administering or coordinating the estate of the deceased. If so, you now know the importance of having an organized estate plan in place (including an up-to-date list of assets, accounts, outstanding liabilities, etc.) so your own heirs won't have to add financial worry on top of their grief when your time comes.
Charitable giving. Another consideration may be donating to charities. Deductibility of gifts to qualified charities is limited to 50% of your adjusted gross income (30% of AGI for long-term assets), with any unused portion eligible for a five-year carryover before it expires. Consider a donor-advised fund such as the Schwab Charitable Fund^TM: You can receive a current deduction in the year your income is temporarily boosted, and then take your time making distributions to the charities of your choice in subsequent years.

Review your portfolio
A large inheritance might warrant significant changes to your investment approach. Depending on your age, goals and previous circumstances, your strategy may shift in one fell swoop from capital accumulation to capital preservation. So, even if you're a relatively young, aggressive investor, consider how much risk you really need to take, regardless of time horizon and risk tolerance. Why take additional risk if you don't have to? In addition to changes in your overall asset allocation, the individual investments you choose may change as well. Given a much larger portfolio, a good portion of which will likely be allocated to fixed income, you may prefer individual municipal bonds to bond funds. This might also be the time to consider a separately managed account, using professional private money managers.

Take care with inherited IRAs
The rules surrounding inherited retirement account balances can get complex, depending on whether the recipient is a spouse or non-spouse and whether the original account holder had begun taking required minimum distributions (RMDs) at the time of death (see "What If You Inherit an IRA?" below). Given the right set of circumstances, you may even be able to "stretch out" the IRA distributions over your lifetime and, potentially, the lives of successive beneficiaries. Be sure to consult with your own professional advisors and account providers for the best choice given your own unique set of circumstances. For more information on inherited IRAs, see Schwab's Inherited IRA Guide on Schwab.com. Also, see IRS Publication 590, "Individual Retirement Arrangements (IRAs)."

What if you inherit an IRA? Consider your options.
Choices	Who Qualifies	When the Money Is Available	Other Considerations
Lump-sum distribution	Spouse or non-spouse	All at once.	Income taxes are paid all at once. No 10% early withdrawal penalty. Your tax bracket may change.
Transfer to an inherited IRA¹ held in your name (distribution based on life expectancy)	Spouse or non-spouse	If deceased was under 70½ , distributions must begin no later than December 31 of the year after the year of the original account holder's death, or December 31 of the year he/she would have reached 70½ , whichever is later. If deceased was over 70½ , an annual required minimum distribution (RMD) over your life expectancy must be taken no later than December 31 of the year following the death. You must also take an RMD for the year of death (if account holder did not already take it).	Annual distributions are determined by your life expectancy and reevaluated each year (or, if deceased was over 70½ , by his/her remaining life expectancy). Each distribution is taxed. No 10% early withdrawal penalty. Undistributed assets continue growing tax-deferred. You can designate your own beneficiary.
Transfer to an inherited IRA¹ held in your name (distribution based on life expectancy)	Spouse or non-spouse if deceased was under age 70½	Any time up until December 31 of the fifth year after the year of the death, at which point all assets need to be fully distributed.	Each distribution is taxed. No 10% early withdrawal penalty. Undistributed assets continue growing tax-deferred. You can designate your own beneficiary.
Transfer into an existing or new IRA in your name	Spouse	At any time.	Available only if spouse is sole beneficiary. Penalty applies to withdrawals made before you reach age 59½ . IRA assets continue to grow tax-deferred. You can designate your own beneficiary. If deceased was over 70½ , you must take an RMD for the year of death (if account holder did not already take it).
Source: Schwab Inherited IRA Guide.

Consider rolling over 401(k)s
Beginning in 2007, a non-spousal recipient (e.g., a child or grandchild) who inherits a 401(k) or other company plan can transfer the balance directly into an inherited IRA. This must be done as a direct trustee-to-trustee transfer from the employer plan to a properly titled inherited IRA in order to avoid adverse tax consequences. If it goes to the non-spouse recipient's own IRA or to a non-IRA account by accident, the distribution is taxable.

Don't count on inheritance
It doesn't hurt to be prepared in case an inheritance comes your way. But also don't count on an inheritance that may not materialize. Make sure you're saving enough money in retirement accounts such as 401(k)s and IRAs. That way, you'll greatly enhance your chances for a comfortable retirement no matter what happens.

1. An inherited IRA allows a spouse or non-spouse beneficiary to keep inherited IRA assets tax-deferred—until the IRS requires the funds in the inherited IRA to be distributed.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in this type of fund.

Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond's market value prior to call or maturity. There is no guarantee that a bond's yield to call or maturity will provide a positive return over the rate of inflation. Bonds are subject to credit, interest-rate, and inflation risks. Bond funds are subject to increased loss of principal during periods of rising interest rates.

Investments in managed accounts should be considered in view of a larger, more diversified investment portfolio. Please read Schwab's Schedule H of Form ADV for important information and disclosures relating to Schwab Managed Account Services™. Services may vary depending on which money managers you choose, and are subject to a money manager's acceptance of the account.

Schwab Charitable Fund™ is the operating name of the Schwab Fund for Charitable Giving®, an independent nonprofit organization. The Schwab Fund for Charitable Giving has entered into service agreements with certain affiliates of The Charles Schwab Corporation (Charles Schwab & Co., Inc. and Charles Schwab Investment Management, Inc.).

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment or investment strategy. All expressions of opinion are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Past results are not indicative of future performance.

Diversification and asset allocation do not eliminate the risk of investment losses.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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