A bequest could change your life, but donât quit your day job.
Weâve all heard stories about individuals who passed away quietly after a life of frugality, leaving a fortune to their unsuspecting heirs or, occasionally, a beloved pet.
The reality is a lot less riveting. Although two-thirds of baby boomers are expected to receive an inheritanceâmostly from parentsâlonger life spans and the rising cost of health care can shrink the size of their parentsâ assets or wipe them out altogether. According to a 2013 study by the Federal Reserve Board, the average bequest for the wealthiest 5% of U.S. households was $1.1 million; for the next 45%, it was $183,000; and for the bottom 50%, it was $68,000.
Complicating matters is the fact that many estates contain a smorgasbord of items, including real estate, investments, cash, retirement savings accounts and life insurance plans. It could take months to track down these assets and divide them among the estateâs heirs, and you could incur significant legal feesâparticularly if the estate was large or your relative died without a will. There are also different rules for different heirs: Spouses, for example, enjoy some tax breaks and exemptions that arenât available for adult children or other heirs.
Brian Lee, 44, of Tacoma, Wash., got a crash course in estate law after his late fatherâs brother and sister died almost within a year of each other, in late 2015 and 2017. Neither of his fatherâs siblings had children when they died, so their estates were divided among their nieces, nephews and other surviving relatives. Lee ended up with a six-figure inheritance, but because his uncle died without a will, settling the estate took months and cost thousands of dollars in legal fees. Leeâs aunt had a will, with Lee as the executor, which made âall the difference in the world in terms of the process,â Lee says.
Unless your parents were fabulously wealthy, you wonât have to worry about federal estate taxes, but that doesnât mean Uncle Sam has no interest in your inheritance.
If you inherited stocks, mutual funds or other investments in a taxable account, youâll be able to take advantage of a generous tax break known as a step-up in basis. The cost basis for taxable assets, such as stocks and mutual funds, is âstepped upâ to the investmentâs value on the day of the original ownerâs death. For example, if your father paid $50 for a share of stock and it was worth $250 on the day he died, your basis would be $250. If you sell the stock immediately, you wonât owe any taxes; if you hold on to it, youâll only owe taxes (or be eligible to claim a loss) on the difference between $250 and the sale price. Itâs a good idea to notify the investment-account custodian of the date of death to ensure that you get the step-up, says Annette Clearwaters, a certified financial planner in Mount Kisco, N.Y.
Because of this favorable tax treatment, a taxable-account inheritance could be a good source of cash for a short-term goal, such as paying off high-interest debt or making a down payment on a house, says Jayson Owens, a certified financial planner in Anchorage, Alaska.
If youâd rather keep the money invested, review your inherited investments to see whether they are appropriate for your portfolio. For example, you could sell individual stocks and invest the money in a diversified mutual fund without triggering a big tax bill.
Retirement accounts. If you inherited a tax-deferred retirement plan, such as a traditional IRA, youâll have to pay taxes on the money. But you can make the tax hit less onerous.
Spouses can roll the money into their own IRAs and postpone distributionsâand taxesâuntil theyâre 70Âœ. All other beneficiaries who want to continue to benefit from tax-deferred growth must roll the money into a separate account known as an inherited IRA. Make sure the IRA is rolled directly into your inherited IRA. If you take a check, you wonât be allowed to deposit the money. Rather, the IRS will treat it as a distribution and youâll owe taxes on the entire amount.
Once youâve rolled the money into an inherited IRA, you must take required minimum distributions every yearâand pay taxes on the moneyâbased on your age and life expectancy. Deadlines are critical: You must take your first RMD by December 31 of the year following the death of your parent (or whoever left you the account). Otherwise, youâll be required to deplete the entire account within five years after the year following your parentâs death.
The December 31 deadline is also important if you are one of several beneficiaries of an inherited IRA. If you fail to split the IRA among the beneficiaries by that date, your RMDs will be based on the life expectancy of the oldest beneficiary, which may force you to take larger distributions than if the RMDs were based on your age and life expectancy.
You can take out more than the RMD, but setting up an inherited IRA gives you more control over your tax liabilities. You can, for example, take the minimum amount required while youâre working, then increase withdrawals when youâre retired and in a lower tax bracket.
Did you inherit a Roth IRA? As long as the original owner funded the Roth at least five years before he or she died, you donât have to pay taxes on the money. You canât, however, let it grow tax-free forever. If you donât need the money, you can transfer it to an inherited Roth IRA and take RMDs under the same rules governing a traditional inherited IRA. But with a Roth, your RMDs wonât be taxed.
Real estate. When you inherit a relativeâs home (or other real estate), the value of the property will also be stepped up to its value on the date of the ownerâs death. That can result in a large lump sum if the home is in a part of the country that has seen real estate prices skyrocket. Selling a home, however, is considerably more complex than unloading stocks. Youâll need to maintain the home, along with paying the mortgage, taxes, insurance and utilities, until itâs sold.
Life insurance. Proceeds from a life insurance policy arenât taxable as income. However, the money may be included in your estate for purposes of determining whether you must pay federal or state estate taxes.
Even a small inheritance can represent more money than youâve ever received at one time. Go ahead and treat yourself to a modest splurgeâa special vacation, for exampleâbut avoid making costly changes in your lifestyle.
Brian Lee used his inheritance to pay off his wifeâs student loans and a small credit card debt; the rest went into retirement savings. Lee says he wanted to honor the legacy of his uncle, a dedicated investor who worked for IBM in the custodial department for 30 years. Leeâs uncle spent most of his life in the same small house in Austin, Texas, and drove a 1967 Ford truck, but he was a wealthy man, with an estate valued at more than $3 million when he died. âThereâs no way I would blow money someone spe