Much of the help we provide clients is focused on saving and investing their money for retirement income. What also matters to us and many clients is the legacy that we leave behind. Sometimes, we also have to plan around inheriting money and trying to make the most of what our loved ones leave behind for us. Though discussing losing loved ones is never easy, and sometimes makes it difficult to consider what to do with assets received or planning for leaving money to others, the implications around what we do with inherited money are impactful.
If you're in this situation and have questions specific to your situation, please reach out so we can discuss your unique scenario. It's also crucial to have this conversation with a lawyer. If you haven't already tackled your estate planning, we'd recommend doing that ASAP. For now, let's discuss some common scenarios and considerations for folks inheriting assets. I'll discuss what someone might consider doing when inheriting, and some examples of how to avoid pitfalls for those planning their own legacy.
- Inherited 401k/IRAs
- Before the original SECURE Act, people who inherited money in pre-tax accounts such as 401ks and IRAs could 'stretch' distributions over the rest of their lives using RMD tables. As of January 1, 2020 folks have only 10 years to withdraw the entire amount and still have to take out required distributions in the meantime. The problem with this is that these dollars have been tax-deferred and we have to pay income taxes on distributions. Inheritance from parents is most likely to come in our 50s1. Do you know the age that is most peoples' peak earnings years and therefore highest tax years? You guessed it - right around the same time, ages 45-55. This is an awful tax trap.
- Solving this problem takes careful planning and consideration, and is unique to each individual. So what are the best options if this happens to you?
- Spread distributions over 10 years. This can help keep some people in lower tax brackets and keep some money potentially growing tax-deferred in the meantime.
- Wait 10 years and leave invested. You are likely required to take out a small amount every year, but if you're already in the highest tax bracket, perhaps just leaving invested the amount not required to be distributed and keeping it tax deferred as long as possible is your best option.
- Take distribution in low tax years. Not everyone can control their taxes, but some business owners and certain types of investors can show lower income taxes in years with greater business expenses or depreciation.
- Take distributions in "down" markets. If you plan on reinvesting the money and expect to see it appreciate over time, then selling when the market is low could result in lower taxes paid and potentially more staying reinvested.
- Increase tax-deferred investments. Someone else doing this may have added to this problem for you, but if you're not already maxing out your tax deferral accounts (think 401k, IRA, HSA, FSA, etc.)
- Invest in your business. Not everyone is in the position to do this and any investment, even one in our own business, should be carefully considered. That said, business owners can often write off expenses to the business. If you've been wanting to grow but were waiting to invest in your business now may be a good time.
- Inherited Roth 401k/IRAs
- The 10-year rule also applies to Roth accounts but without the RMD rule. Generally speaking, it would make sense to keep it in the Roth account as long as possible to maintain tax-free growth, but this is tax-free money so the only thing you lose by taking it is future tax-free growth.
- If you can convert money from Traditional to Roth during your lifetime, you can see how this can be a powerful estate planning tool. It may benefit you as well. This strategy should be considered with careful planning.
- Inherited Brokerage Accounts
- Taxable investments generally receive what's called a step-up in cost basis. When you buy an investment, the amount you purchase it for is your cost basis. Any amount you sell the investment for in excess of your cost basis is generally considered a capital gain. When we pass assets on when we die, our beneficiaries generally receive a step-up in the cost basis to the value on the day of our passing. So if you bought a stock for $10,000 and it grows to $100,000 you have a $90,0000 unrealized capital gain. However, if you were to pass without selling or gifting that stock, your heirs would have a cost basis of $100,000. This allows them to sell the stock without realizing any capital gains.
- Inherited Property
- Similar to taxable accounts, beneficiaries generally receive a step-up in cost basis on real property. This is why we generally recommend not gifting property prior to passing, but utilizing trusts to protect the property from a variety of risks and to ease the burden of the probate process.
- Inherited Business Interest
- Though there may be some advantages of step-up in cost basis, this is much more complicated. It's important to understand the valuation and cash flow of the business. It's also important to have a succession plan, especially for businesses that are owned by multiple parties. Business succession planning should be done long before anyone would expect to pass it on. You can have an agreement to pass the ownership of the business to your heirs, or you can have an agreement to pass to a 3rd party with a pre-determined formula for a buyout they will pay to your estate or to your heirs. Generally, you want to include provisions for disability or untimely death. If there are multiple shareholders or partners in the business, everyone must understand and agree to the provisions of all documents.
- What about estate taxes?
- No one likes the idea of paying estate taxes, but the reality is a very small part of the population will have to consider federal estate taxes. As of my writing this in 2024, the federal estate tax exemption is $13.61 million per individual or a combined $27.22 million for a married couple3.
- That said, some states have their own estate tax and the rules vary, so check with your advisor, lawyer, or CPA.
- Connecticut (where Bergenn Financial Group operates) has an estate tax that mirrors the federal exemptions.
- Our neighbors in Massachusetts have a much tougher estate tax to contend with. Estates over $2,000,000 may have to pay estate taxes and the entire estate is taxed, not just the amount over $2,000,000.
- If you know you have more than the amount that qualifies for the exemption, especially the federal exemption, you should start planning immediately with a financial advisor and and trust and estates attorney. Contact us and we can help you find a vetted attorney and work with them to devise an investment plan for your assets.
- Other Considerations
- Long Term Care: Long term care costs can play a huge role in the value of an estate left behind. Family estates often lose a considerable amount to these costs, but this can be protected with some careful planning.
- Family Dynamics: No matter how well your family gets along, if you throw some money and emotions in the mix, relationships can be tested. It's important to be very clear about your wishes and name executors, trustees, etc. who can manage this process, even if that means making trustees someone who is not a beneficiary.
- Gifting: It's important to understand how to manage charitable giving. If you have plans to support charities, this can have a huge impact on how you name beneficiaries and how you set up trust and estate documents.
Estate Planning and passing on assets is a dense topic. But it may also be the highest impact part of your financial planning, even if it impacts people other than you. If you have questions, regardless of your need for our services, please reach out to us so we can answer any basic questions and provide referrals to other professionals. We're happy to be a resource for you and your family.
- https://www.washingtonpost.com/business/2023/11/10/inheritance-america-taxes-equality/
- https://www.statista.com/statistics/817928/mean-personal-money-earnings-in-the-us-by-age/
- https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax