Heir Economics

January 20, 2012

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

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, versus 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 generally 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 the holding period shouldn't 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 might 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 a basic will 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™: 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 the table 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 step-by-step decision guide for retirement account beneficiaries. Also, see IRS Publication 590, Individual Retirement Arrangements (IRAs).

Consider rolling over 401(k)s

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 an 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 whether you inherit money or not.