How to Make the Most of an Inheritance
It is estimated that over the next two decades, Baby Boomers will pass down a whopping $68 trillion worth of assets to younger generations. Receiving an inheritance should be considered a blessing, but if not handled correctly it can quickly become a curse. If you’re not careful, you run the risk of losing your money just as quickly as you receive it. According to a study conducted by the Bureau of Labor Statistics, one-third of people who receive an inheritance spend all of it in the first two years. With some sensible planning and foresight, you can make sure that your inheritance takes care of you and your family long after you receive it.
Here are some ideas to help set you on the right course with your newfound wealth.
First, take time to grieve and don’t make decisions right away. When you lose a loved one, you’re not thinking clearly enough to make sound financial decisions. Deciding what to do with an inheritance during this period can be overwhelming, upsetting, and cause confusion. There is nothing wrong with letting your inheritance sit for a while until you are ready to focus and develop a plan.
Once you are ready to move forward, you need to understand the type of inheritance that you are getting. Most inherited assets fall into three major categories, real estate, such as a house or property; retirement accounts, such as an IRA or 401(k), and bank or brokerage accounts. Depending on the type and amount of assets you inherit, you may need to seek counsel from highly qualified professionals who can help you understand all your options such as a real estate agent, a tax advisor, an investment professional, or an estate attorney.
If you inherit a house, you have three options. You can sell it, rent it, or live in it. If you decide to sell the house, first you need to determine if the house is paid off or still has a mortgage. If the house has a mortgage, you will receive the proceeds of the sale price after the mortgage balance is paid. Also, the value of the house is usually higher than what the original owner paid for it. If that is the case you will receive a step up in cost basis, which will decrease your capital gains taxes when the house is sold. You only pay taxes on the difference between the value of the house at the time of death and the selling price. Renting the house could create another stream of income. However, keep in mind that ongoing upkeep and maintenance will reduce that income stream. Also, if you are not particularly handy, hiring out the management of the property will make this venture less lucrative. Living in the house could be a great option if you’re not happy with your current living arrangement. Some things to consider when making this decision is the mortgage paid off? What are the annual maintenance costs and property taxes compared to your current situation?
When inheriting retirement assets, it is extremely important to consider the tax ramifications when taking distributions. Retirement assets do not receive a step up in cost basis, as do other asset classes. Distributions from Roth IRA and Roth 401(k)s are not taxable, however distributions from the Traditional counter parts are taxable at ordinary income tax rates. Keep in mind that the Secure Act that was passed in 2020 has changed the distribution rules. Required minimum distributions are now only required for inherited IRA’s created prior to 2020. Inherited IRAs created in 2020 and beyond don’t have annual RMD’s—however, individual beneficiaries are required to fully liquidate the inherited IRA 10 years from the date of death of the original depositor, and trust beneficiaries are required to fully liquidate in five years. Another important consideration to evaluate when inheriting retirement assets is the existing investment allocation. If you are not comfortable managing these investments yourself, it is critical that you find a professional to manage them appropriately.
When inheriting cash from a bank account or stocks and mutual funds in a brokerage account, the tax consequences are less of a factor due to step up in cost basis. However, the liquid nature of this asset class gets many people into trouble. I know it is not exciting, but before you spend a dime, you need to evaluate your current financial situation. First, if you have any high-interest debt, it is always a good idea to eliminate as much of it as possible. Paying off debt, will give you a lot more financial flexibility in the future. Next, set up an emergency fund; having three to six months’ worth of expenses saved in a rainy-day fund will help you deal with life’s unexpected curve balls. In order to provide for a secure financial future, it is important to invest the remainder of the inheritance for growth. Although investing involves risk, leaving the inheritance in a bank account is not without risk, the loss of purchasing power over time due to inflation combined with the low interest rates paid by banks is a real issue to consider. At Provident Investment Management, we believe a portfolio fully invested in stocks can sustain a 5% annual withdrawal rate, while continuing to grow for the long term.
As with all types of investment accounts, if you do not feel comfortable managing investments yourself, hiring a professional investment manager is strongly encouraged. In the meantime, if you have any questions dealing with an inheritance or investing in general, reach out to us and we’ll help you understand all of your options.
Dan Krstevski, CFP®