68% of millennials and Gen Zers have received or expect to receive an inheritance. If you are one of these people, you should feel extremely fortunate. And inheritance can drastically change your financial life if you plan well. And to be honest, you owe it to your family to plan well with these dollars. They worked hard to earn it so your life could be better.
So how should you plan with the inheritance you are getting? In this post we will go through the various types of assets/accounts you may inherit and how to plan around them.
Let’s get into it.
The type of account you are inheriting makes a huge difference on how you plan around the dollars.
1) Taxable account/Real Estate
These are two of the easiest to plan for. When you inherit these assets, you get a step up in cost basis. This means, even if your parents bought $10 of Apple stock and it’s worth $1,000,000 today, you do not have a cost basis of $1,000,000. The price on the date they pass away is your new cost basis. This is incredibly impactful.
This means you can sell and reallocate and do whatever you want with the funds. Maybe you want to:
It makes it really easy to do this because you do not have to worry about tax in the same way. I have watched a lot of people hold onto the same investment simply because they did not understand how taxes work here.
2) Roth Accounts (Roth IRA, Roth 401(k), etc)
Roth accounts require you to withdraw funds within 10 years, in most cases just like pre-tax accounts. Honestly, Roth accounts are the best thing you can inherit. If you need some or all the funds now for a specific goal, you can take every dollar out and none of it counts as income. However, you are giving up a ton of the benefits if you do that. You could however leave the funds in there and allow them to grow tax free till the 10th year, then take them all out. An extra 10 years of tax free growth is super impactful. It really all comes down to your goals and if you need those funds.
3) Traditional Accounts (IRA, 401(k), etc.)
Pre-tax accounts require you to withdraw funds within 10 years, in most cases like Roth accounts. Pre-tax accounts require a ton of planning.
Why?
Most people are getting inheritances in their 40s and 50s which are their highest income earnings years. When you take funds out of these pre-tax accounts, they all count as income and will push you up tax brackets. Taking out $1,000,000 at the 37% bracket means you lose $370,000 to federal taxes.
So how do you best plan here?
There are a few things to consider. If you are in the 37% bracket and plan to be there every year, then you can take the funds out however you want. If you are lower though, you will want to plan more than that. If you took all the funds out in year 1, you would pay a way higher effective rate than doing it over 5-10 years and optimizing the brackets you are in.
You also could consider some tax planning moves to lower your tax rate. This could be:
It pays to do real tax planning here so you can keep more of this money and pay less in taxes. Oftentimes, when doing your estate planning, you will not want to pass on wealth to your kids equally with each account. It may make sense to have lower income kids get more pre-tax money and higher income kids to get more Roth or taxable money so less taxes are paid.
4) Life Insurance
This is very similar to taxable accounts. You will get the dollars and can do whatever you want with them.
At the end of the day, you need to understand your financial situation, your goals, your tax rate, how each part of your inheritance will be taxed, etc. so you can allocate your dollars wisely and minimize the tax burden on your life. These are the times it really makes sense to have an advisor.
I have a client who wishes they hired us 5 years earlier. They inherited a 401(k) that has a 5 year withdrawal requirement. They didn’t do anything the first 4 years and then had 1 year to take the funds out. This pushed them into the 37% bracket and they paid over $150k more in taxes than they needed to. If they were with us before, we would’ve helped funnel those funds into a solo 401(k) they could have setup with their business and essentially offset all those dollars coming in.
It pays to have an expert alongside you in these times!
Financial Advisor