Ashes to ashes, dust to dust. An individual much more adept at the English language than me came up with that one.
People come onto this Earth and pass away, it’s the inevitable truth about our existence.
Some of those people are those who care about us; they are family, friends or long lost Aunt Gertrudes who you’ve never met before in your life.
These people from time may leave you money after their death and the question you may have is how do I not go spend it all on a weekend to Vegas. Well some of you that is..
How do I make the most out of my inheritance?
Some of you would like to honor that person who thought enough of you to leave behind a sum of money to do with as you wish.
To do this, it’s best to know the manner in which the money was left to you. This affects how and if your inheritance will be taxed and how you will have the ability to access the money.
In this post we will look at the manner in which inherited money may come to you (obviously with someone passing away but if it was through a Trust or retirement accounts), what potential inheritance or estate taxes you may face and some suggestions to how an inheritance may best be utilized (depending on your own financial situation).
So let’s get started..
Where did this money come from?
The simple answer to this question would be from someone who passed away and cared enough about you to leave behind a monetary gift for you. Alright wiseguy that was obvious but there are specific vehicles that the money can be left to you.
If the money came from a trust then the money you receive and the manner in which you receive it is subject to the terms of the trust that your benefactor (aka the person who passed away and gave you the money) laid out.
There will also be a trustee involved. A trustee is the person, corporation or bank that is in charge of making sure the terms of the trust are carried out.
Different rules apply if you’re inheriting retirement accounts such as a 401k or IRAs.
These accounts are tax-deferred, meaning that taxes have not been paid out but once the money is accessed the good ole’ IRS will come knocking.
They will come knocking by making you take the money out of your inherited retirement accounts so that you will have to pay taxes on them. By taking distributions from inherited retirement accounts, you will most likely pay income tax on the money being withdrawn.
This is how Uncle Sam will make you take distributions:
- He will make you take a lump-sum which is great if you want all the money now, probably bad if you don’t want to float a potentially hefty tax bill all at one time.
- You will have to withdraw the money five years from the time your benefactor passed away. All things considered this is not a bad option. It prevents you from getting your grubby paws on the inheritance all at one time and spreads out the tax bill over the course of five years.
- You will withdraw the money based on your own life expectancy. There are a few notes here; the IRS has mathematical tables that calculate when you’ll probably die. These tables determine the rate at which you are to withdraw the money from the inherited retirement accounts, thus determining how often and how much tax you will pay on that money.
Your inheritance could be as simple as a bank account. Wonderful! However there still may be some inheritance taxes and estate taxes that must be paid that change from state to state.
Let’s take a look at the taxes you could pay…
As always, Uncle Sam is going to want to collect. There are three potential taxes that you may pay when receiving an inheritance.
Only six states currently impose a State Inheritance Tax. These states are Iowa, Kentucky, Pennsylvania, Nebraska, New Jersey and Maryland.
So congratulations, if the person who passed on money to you didn’t live in one of these states, you’re free of inheritance tax.
Similar to inheritance taxes, only a number of states collect them. They include Minnesota, New Jersey, New York, Oregon, Rhode Island, Washington, Vermont, Tennessee, the District of Colombia, Hawaii, Illinois, Massachusetts, Maryland, Main, Delaware and Connecticut.
If the person you inherited money from didn’t live in one of these states congratulations, you don’t owe state estate taxes.
Federal estate taxes are a slightly different animal. In 2017, the estate and gift tax exemption is $5.49 million per individual. In other words, if the person that so graciously left you an inheritance leaves behind $5.49 million or less to their heirs they will not have to pay any federal estate or gift tax.
The inheritance itself is not considered income so it will not have to be reported on a tax return.
As mentioned before, if the money inherited was in a retirement account then you will be forced to take the money out and have that money included in your federal income and possibly your state income as well.
If the money is in a trust or anywhere outside of a retirement account, taxes on any capital gains of the property would potentially have to be paid.
Take note that you receive a “stepped-up” basis on the property you inherited. The difference between your basis and what you sold the property for is considered the capital gain that you will pay tax on.
For example, assume that you were left behind a house that was worth $400,000 on the day the person who left you the house passed away (this is the basis). Five years later you sell the house for $500,000. The $100,000 difference between the $500,000 sale price and the $400,000 basis is the gain of $100,000 that you would have to pay tax on.
So now that you have the money what exactly do you do?
Take a financial timeout or as we would say in college after a long day of shenanigans, “let’s take a 30.”
Inheriting a substantial sum of money is not a situation you want to dive head first into the minute you get up to the diving board. Park that money in a savings account and give it a couple weeks to take stock of what your financial situation is and what your financial goals are moving forward.
Here are a couple ideas once you take that timeout…
Everybody’s financial situation is unique to them so what one person does with an inheritance may not be the best option for another. That being said, here are a couple ideas for your inheritance (once again) depending on your financial goals.
Create a “rainy day” fund
If you do not have a rainy day fund I highly recommend that this is the first thing you do when you receive an inheritance. You never know when your car might break down, you break a leg or you lose your job.
The rule of thumb here is that you set aside at least 3 months worth of living expenses. So good news here, if you received a hefty inheritance then even with the newly established rainy day fund you’ll still probably have money left over!
Pay off debt
Oh boy, this is not a fun one to think about but it’s incredibly important. If you have outstanding high interest debt from credit cards or personal loans probably a good move to use that inheritance and knock it out.
Other types of debt such as mortgages may not want to be tackled right away with an inheritance, once again we go back to that whole “it depends on your unique financial situation” disclaimer.
Okay so investing an inheritance can be a great way to honor the person who gave you the money by potentially growing it into the future. But always remember, WHERE you invest the money is dependent upon WHY it is you are investing the money.
In other words, your goals with your inheritance are the driving force behind how that money is invested.
If you’re investing the money for a long-term goals such as a down payment in 10 years then putting the inheritance in a balanced portfolio of stocks and bonds may be the right call.
On the other hand if your inheritance is going to be used to finance a more nearer-term goal then having the money in some sort of high-yield savings account or money market account could be the correct course of action.
Save for a down payment
What’s one of the most difficult aspects of purchasing a home? If you said coming up with the down payment then you are correct!
Using a significant inheritance for a down payment on a house may be a great way to utilize your windfall, especially if the down payment is your main barrier to owning a home.
Use caution here however because although the monthly mortgage payments may seem manageable, there are always unforeseen costs in owning a home such as closing costs, maintenance, repairs, higher utility bills and taxes/insurance included in your mortgage.
Wait what? Okay maybe “bender” isn’t a choice use of words here but I think going out and having fun with a portion of the money is a decent proposition.
Assume you paid off any outstanding debt you had, invested a portion of the money, established that “rainy day” fund and had all other of the personal finance boxes checked (maximizing retirement accounts, positive monthly cash flow etc).
Then why not go out and have fun with the remainder? I’m sure the person who left you the money would want you to enjoy it responsibly to a certain extent. Go on a vacation or make that impulse purchase (within reason). If everything else is taken care of then go for it.
Well there you have it. While receiving an inheritance can be a very financially liberating occurrence, it is often accompanied by many tax and financial complexities that most of us are not familiar with.
When in doubt, it may be wise to not try and handle the taxes/inheritance alone. Consider consulting with an estate planning attorney, accountant and/or a financial advisor to help guide you through the process of receiving a substantial inheritance.
Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.