January 20, 2012
- Learn how to make the most of an inheritance.
- Depending on the size of the inheritance, you might need to create or revamp your financial plan.
- When you're trying to cope with the loss of a loved one, dealing with financial matters may be the last thing on your mind—so it's often a good idea to park the money in a relatively safe place until you're ready.
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).
|Your Options for an Inherited IRA|
|Choices||Who qualifies||When the money is available||Other considerations|
|Lump-sum distribution||Spouse or non-spouse||All at once.||
|Transfer to an inherited IRA1 held in the name of the original account holder for your benefit (distribution based on life expectancy)||Spouse or non-spouse||You can access your funds at any time and are taxed on each distribution.
|Transfer into an existing or new IRA in your name||Spouse||At any time.||
Source: "You've just inherited a retirement account. Now what?" Schwab, 2010.
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.
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.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
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.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
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.).
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.