Tips for Making the Most of Your Inheritance
Understand your goals and identify key risks and gaps in your financial plan.
Account for the type of assets you will inherit so you know your options and the tax ramifications.
Develop a strategy that maximizes the potential of your inheritance and helps you accomplish your goals.
Baby boomers in the U.S. are set to bequeath $68 trillion in wealth by 2043, as part of the Great Wealth Transfer. Much of that will be left to Generation X and millennial heirs. If you expect to receive an inheritance, planning for how you will use the wealth and accounting for any taxes will help you make the most of your windfall.
If you will inherit money...
If you stand to inherit a significant amount of money, earmark it toward financial goals ahead of time so you know that you will be most productive with those dollars. Here are a few options to consider:
Pay off high-interest debt.
High-interest debts such as credit card debt and personal loans eat away at your efforts to build savings. Pay off debts to save on interest and free up cash for other financial goals. Is your credit card charging you 20% interest? Paying it off is the fastest way to a 20% return on your money.
Make a down payment on a home.
While putting down 20 percent or more of the purchase price will lower your monthly mortgage payments, this is not required nor always prudent depending on your personal situation and the interest rate environment. The younger you are, the more time you have for the money you invest to be growing and compounding for you. If you instead use those funds as a large down payment, that money is locked up in your house until you decide to sell, thus missing out on years of potential growth.
Pay off existing mortgage.
Many are quick to put extra cash towards their mortgage, but that is rarely the most productive use of money. Before making that big payment, think of it through a few different lenses.
Once you apply money towards the principal of your mortgage, there’s no going back. When “life” happens and you need that money for something else, it’s tied up in your home until you sell or get another mortgage.
How long will it take me to get my money back? Let’s say you pay off your $200,000 mortgage and save yourself $1,200 per month in principal and interest. It will take you 167 months, or almost 14 years, to get your $200,000 back.
3. Return on Investment
By paying down your mortgage, you are essentially investing in your home. Don’t forget that home values are still tied to a market, and it takes time and money to sell a home. Ask yourself, “Can I earn more than the interest rate I am exposed to in a long-term investment strategy?" Typically, that answer is yes, especially in this low interest rate environment. If your interest rate is high, evaluate the options to refinance the mortgage.
Save for retirement.
Use your windfall to supplement spending needs, so you can boost savings in tax-advantaged retirement accounts that use payroll deductions, such as a 401(k) or 403(b). In 2021, you can save up to $19,500 in your 401(k), or $26,000 with catch-up contributions for those age 50 and older. Depending on your contribution elections, money invested in the account grows tax-deferred or tax-free.
If you will inherit a house...
Real estate can make a more complicated inheritance. Here are two important questions to help you prepare to inherit a house:
What are the costs?
Unlike a cash inheritance, a real estate inheritance can come with financial obligations. If you have been told that one day the family house will be yours, find out ahead of time what costs you may need to cover should you decide to keep the home. First, is there a mortgage? If so, do the terms of the mortgage allow you to take over payments, or do they require the mortgage balance to be paid in full when the property transfers ownership? Also, be aware of property taxes and maintenance costs. If you are not readily able to cover these costs, you may consider selling the home.
Is the inheritance shared?
It is not uncommon for siblings to inherit a piece of property together. If that is your situation, then the most important thing is understanding each heir’s wants and needs. Then you can decide whether it makes sense to sell the home and split the profit, rent it out jointly, or keep it in the family by having one heir buy out the others’ shares.
Before you can be sure exactly how much you will be getting from an inheritance, you have to consider the tax bill. How much you might owe depends on several factors:
In general, you do not owe income taxes on an inheritance. An exception occurs when you have inherited the right to receive payments, say from a traditional IRA or 401(k).
10-year rule – The SECURE Act created a major change in the inherited IRA distributions rules. If you inherit assets from a traditional IRA and you are a non-spousal beneficiary, you are required to withdraw all assets in the account within 10 years, which provides less control over managing the tax exposure. If the current IRA owner is in a low tax bracket, converting some of these dollars to a Roth IRA today should be a consideration. When Roth assets are passed down to the beneficiary, distributions have the potential to be taken tax-free.
Federal estate taxes — charged to the estate — are not levied on estates worth less than $11.7 million. Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington, and the District of Columbia levy estate taxes on people who lived or owned property within their borders.
Inheritance taxes — charged to the heir — do not exist at the federal level, though Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania levy their own on inheritances from decedents who lived or owned property in those states. Often, closely related heirs are exempt from these state inheritance taxes.
Capital gains taxes – If you sell a home you inherited for more than its fair market value at the time you inherited it, you will realize a capital gain and potentially owe capital gains tax. You may avoid all or part of this tax if you use the house as your primary residence for two years out of a five-year period before selling.
Planning for inheritance is an important part of staying on top of your personal finances. It will help you decide how much you need to save for your financial goals and the steps you need to take today, so the bequest can do the most good in the future.
However, sometimes you do not get the chance to plan for this inheritance. Between coping with the sudden loss of a loved one and inheriting assets you did not previously account for, this can be a stressful and emotional time. Make sure you have trusted resources and professionals in your corner who have your best interest at heart and can objectively help you evaluate your options based on your financial goals.
Katie Blechschmidt, CFP®
Private Wealth Advisor