Wealth
Due to Inheritance
What
is it?
Introduction
If
you're the beneficiary of a large inheritance, you may find yourself suddenly wealthy.
Even if you expected the inheritance, you may be surprised by the size of the bequest or
the diverse assets you've inherited. You'll need to evaluate your new financial position,
learn to manage your sizable assets, and consider the tax consequences of your
inheritance, among other issues.
Issues
that arise in connection with an inheritance
If
you've recently received a bequest, consider the possibility that the will may be
contested if your inheritance was large in comparison with that received by other
beneficiaries. Or, you may decide to contest the will if you feel slighted. If you're the
spouse of the decedent, you may elect to take against the will. Taking against the will
means that you're exercising your right under probate law (governed by the statutes of
your state) to take a share of your spouse's estate, rather than what your spouse left you
in the will, because this is more beneficial to you. Another possibility is that you may
disclaim the bequest if you're in a high income or estate tax bracket, or don't need or
want the bequest.
Tip: If
you've inherited assets from your spouse or a family member, you may be in charge of
settling the estate, claiming survivor's benefits, and dealing with other financial and
emotional issues at a time when you're grieving. For more information on these issues, see
Loss of a Spouse/Family Member.
Caution: Some
states allow no-contest clauses to be included in wills. If a will has such a clause and
someone contests the will and loses, he or she gets nothing.
Evaluating
your new financial position
Introduction
It's
important to determine how wealthy you are once you receive your inheritance. Before you
spend or give away any money or assets, decide to move, or leave your job, you should do a
cash flow analysis and determine your net worth as a first step toward planning your
financial strategy. Your strategy will partly depend on whether you have immediate access
to, and total control over, the assets, or if they're being held in trust for you. In
addition, you need to know what types of assets you've inherited (e.g., cash, property, or
a portfolio of stocks).
Inheriting
assets through a trust vs. inheriting assets outright
When
you inherit money and assets through a trust, you'll receive distributions according to
the terms of the trust. This means that you won't have total control over your inheritance
as you would if you inherited the assets outright. With a trust, a trustee will be in
charge of the trust. A trustee is the person who manages the trust for the benefit of the
beneficiary or beneficiaries. The initial trustee was named by the individual who set up
the trust. The trustee will likely be your parent or other family member, a close family
friend or advisor, an attorney, or a bank representative. The trust document may spell out
how the trust assets will be managed and how and when trust income and assets will be paid
to you, and it will outline the duties of the trustee.
Know
the terms of the trust
If
you're the beneficiary of a trust, the following should be done to ensure that your
interests are protected:
·
Read
the trust document carefully. You have the right to see the document, so if you can't get
a copy, hire an attorney to get it. Go over the document yourself or with the help of a
legal or financial professional, making sure you understand the language of the trust and
how its income and principal will be distributed to you. You may be the beneficiary of an
irrevocable trust (can't be changed), or you may be the beneficiary of a revocable trust
(can be changed). In addition, determine whether certain practices are allowed or
prohibited. For example, one common trust provision prohibits a beneficiary from borrowing
against the trust. Another can prevent the beneficiary from paying creditors with assets
of the trust. An additional provision usually prohibits creditors from attaching a
beneficiary's share of the trust.
·
Determine
if the trust income is sufficient to meet your needs. Is the trust heavily invested in
long-term growth stocks or nonrental real estate? Or, is the trust invested in things that
provide income to you now, such as rental real estate or money market funds? From your
agent (e.g., attorney, accountant) or trustee, get the income statements used to calculate
how much income will be distributed to you.
·
Get
to know your trust officers (if any) and find out how much the trustee fees are. Then,
compare the fee with the average in your state or county (you might ask your local bank
for this information). You may be able to negotiate the fee if it is too high, especially
if the estate is large.
Working
with a trustee
In
some trusts, the trustee must distribute all of the income to the beneficiary every year.
This type of trust may be simple to administer and relatively conflict free. You may want
to work with the trustee or other professionals to ensure that the annual trust
distribution is adequate to meet your needs.
In
other trusts, the trustee may decide when to distribute trust income and how much to
distribute. If this is the case, open communication with the trustee is important. You'll
need to set up a sound budget or financial plan and carefully prepare your request for a
trust distribution if it is out of the ordinary. It's in your best interests to find a way
to work with the trustee. In most states, trustees are difficult to replace, and although
they're not supposed to lose money on investments, they're not usually penalized if the
trust performs poorly. If you decide to sue the trustee for mismanaging the trust, his or
her legal fees may be paid for from the trust.
Caution: No
matter how trust funds are distributed, pay close attention to how the trustee handles the
trust investments. Have your lawyer, accountant, or financial advisor look over the
trustee's investment strategy. If your advisor determines that the trustee's investment
strategy doesn't meet your needs or, worse, is unsound, discuss this strategy with the
trustee or possibly ask the trustee to change his or her strategy.
Inheriting
a lump sum of cash
When
you inherit a large lump sum of cash, you'll be responsible for managing the money
yourself (or hiring professionals to do so). Even if you're used to handling your own
finances, becoming suddenly wealthy can turn even the most cautious individual into a
spendthrift, at least in the short run. Carefully watch your spending. Although you may
want to quit your job, move, gift assets to family members or to charity, or buy a car, a
house, or luxury items, this may not be in your best interest. You must consider your
future needs, as well, if you want your wealth to last. It's a good idea to wait a few
months or a year after inheriting money to formulate a financial plan. You'll want to
consider your current lifestyle, consider your future goals, formulate a financial
strategy to meet those goals, and determine how taxes may reduce your estate.
Inheriting
stock
You
may inherit stock either through a trust or outright. The major question to consider is
whether you should sell the stock. This depends on your overall investment strategy and
what type of stock you've acquired. If you acquire stock in a company, for example, and
you now own a controlling interest, you'll need to look at how actively you want to be
involved in the company or how much you know about the company. If you inherit stock and
find that it doesn't fit your portfolio, you may consider selling it, depending on the
market conditions.
Inheriting
real estate
If
you inherit real estate, such as a house or land, you'll probably have to decide whether
to keep it or sell it. If you keep it, will you live there or rent it out? Do you hope
that the house will appreciate in value, or are you keeping it for sentimental reasons? If
you decide to sell or rent the house, you'll need to consider the tax consequences, as
well. For more information, see Personal Residence and Vacation Home Tax Planning.
Tip: It's
possible that you may inherit real estate or other assets together with others, and sales
may require the other owners' assent or court action to sever the property.
Short-term
and long-term needs and goals
Once
you've done a cash flow analysis and determined what type of assets you've inherited, you
need to evaluate your short-term and long-term needs and goals. For example, in the short
term, you may want to pay off consumer debt such as high-interest loans or credit cards.
Your long-term planning needs and goals may be more complex. You may want to fund your
child's college education, put more money into a retirement account, invest, plan to
minimize taxes, or travel.
Use
the following questions to begin evaluating your financial needs and goals, then seek
advice on implementing your own financial strategy:
·
Do
you have outstanding consumer debt that you would like to pay off?
·
Do
you have children you need to put through college?
·
Do
you need to bolster your retirement savings?
·
Do
you want to buy a home?
·
Are
there charities that are important to you and whom you wish to benefit?
·
Would
you like to give money to your friends and family?
·
Do
you need more income currently?
·
Do
you need to find ways to minimize income and estate taxes?
Tax
consequences of an inheritance
Income
tax considerations
In
general, you won't directly owe income tax on assets you inherit. However, a large
inheritance may mean that your income tax liability will eventually increase. Any income
that is generated by those assets may be subject to income tax, and if the inherited
assets produce a substantial amount of income, your tax bracket may increase. Once you
increase your wealth, you should look at ways to minimize your overall tax liability, such
as shifting income, giving money to individuals or charity, utilizing other income tax
reduction strategies, and investing for growth rather than income. You may also need to
re-evaluate your income tax withholding or begin paying estimated tax. For more
information, see Tax Planning for Income.
Estate
tax considerations
If
you're wealthy, you'll need to consider not only your current income tax obligations but
also the amount of potential federal estate taxes and state death taxes that your
beneficiaries may have to pay upon your death. If your estate will be worth more than the
applicable exclusion amount ($1.5 million in 2004 and 2005), consider looking at ways to
minimize potential estate taxes. Four common ways to minimize potential estate taxes are
to (1) set up a marital trust, (2) set up an irrevocable life insurance trust, (3) set up
a charitable trust, or (4) make gifts to individuals and/or to charities. For more
information, see Federal Gift and Estate Taxes (the Unified Transfer Tax System) and State
Death Taxes.
Tip: The
Economic Growth and Tax Relief Reconciliation Act of 2001 increases the estate tax
applicable exclusion amount to $2 million in 2006 through 2008, $3.5 million in 2009, and
is scheduled to repeal the tax for one year effective 2010. Also, in 2010, the current
rule allowing a basis step-up at death will be replaced with carryover cost basis.
However, current federal estate tax law is scheduled to be reinstated in calendar year
2011 (this is known as the Sunset Provision).
Impact
on investing
Inheriting
an estate can completely change your investment strategy. You will need to figure out what
to do with your new assets. In doing so, you'll need to ask yourself several questions:
·
Is
your cash flow OK? Do you have enough money to pay your bills and your taxes? If not,
consider investments that can increase your cash flow.
·
Have
you considered how investing may increase or decrease your taxes?
·
Do
you have enough liquidity? If you need money in a hurry, do you have assets you could
quickly sell? If not, you may want to consider short-term, rather than long-term,
investments.
·
Are
your investments growing enough to keep up with or beat inflation? Will you have enough
money to meet your retirement needs and other long-term goals?
·
How
risky are your investments? Often, the more risk you take, the higher your return in the
long run. However, consider your tolerance for risk. Are you willing to risk losing part
or all of the inheritance you've invested?
·
How
diversified are your investments? Don't put all your eggs in one basket. If you diversity
your investments, you decrease your risk.
For
example, suppose you inherit an assortment of high-tech stocks. If the computer industry
has a bad year, all of your stocks may decline in value. But if you diversify by selling
some high-tech stocks and investing some of that money in utilities, some in international
stocks, and some in blue chip stocks, you have decreased the likelihood that all of your
stocks will perform poorly at the same time.
Once
you've considered these questions, you can formulate a new investment strategy. However,
if you've just inherited money, remember that there's no rush. If you want to let your
head clear, put your funds in an accessible interest-bearing account such as a savings
account, money market account, or a short-term certificate of deposit until you can make a
wise decision with the help of advisors.
Impact
on insurance
When
you inherit wealth, you'll need to re-evaluate your insurance coverage. Now, you may be
able to self-insure against risk and potentially reduce your property/casualty,
disability, and medical insurance coverage. (However, you might actually consider
increasing your coverages to protect all that you've inherited.) You may want to keep your
insurance policies in force, however, to protect yourself by sharing risk with the
insurance company. In addition, your additional wealth results in your having more at risk
in the event of a lawsuit, and you may want to purchase an umbrella liability policy that
will protect you against actual loss, large judgments, and the cost of legal
representation. If you purchase expensive items such as jewelry or artwork, you may need
more property/casualty insurance to protect yourself in the event these items are stolen.
You may also need to recalculate the amount of life insurance you need. You may need more
life insurance to cover your estate tax liability, so your beneficiaries receive more of
your estate after taxes. For more information, see Tax Planning with Life Insurance.
Impact
on estate planning
Re-evaluating
your estate plan
When
you increase your wealth, it's probably time to re-evaluate your estate plan. Estate
planning involves conserving your money and putting it to work so that it best fulfills
your goals. It also means minimizing your exposure to potential taxes and creating
financial security for your family and other intended beneficiaries. For more information,
see Introduction to Estate Planning.
Passing
along your assets
If
you have a will, it is the document that determines how your assets will be distributed
after your death. You'll want to make sure that your current will reflects your wishes. If
your inheritance makes it necessary to significantly change your will, you should meet
with your attorney. You may want to make a new will and destroy the old one instead of
adding codicils. Some things you should consider are whom your estate will be distributed
to, whether the beneficiary(ies) of your estate are capable of managing the inheritance on
their own, and how you can best shield your estate from estate taxes. If you have minor
children, you may want to protect them from asset mismanagement by nominating an
appropriate guardian or setting up a trust for them.
Using
trusts to ensure proper management of your estate and minimize taxes
If
you feel that your beneficiaries will be unable to manage their inheritance, you may want
to set up trusts for them. You can also use trusts for tax planning purposes. For example,
setting up an irrevocable life insurance trust may minimize federal and state estate taxes
on the proceeds. For more information, see Trusts.
Impact
on education planning
You
may want to use part of your inheritance to pay off your student loans or to pay for the
education of someone else (e.g., a child or grandchild). Before you do so, consider the
following points:
·
Pay
off outstanding consumer debt first if the interest rate on your consumer debt is higher
than it is on your student loans (interest rates on student loans are often relatively
low).
·
Paying
part of the cost of someone else's education may impact his or her ability to get
financial aid. For more information, see Gifting for Education Savings.
·
You
can make gifts to pay for tuition expenses without having to pay federal gift tax if you
pay the school directly. For more information, see Implementing Other Creative Solutions
to Cover Higher Education Costsand Make Tax-Free Gifts of Tuition.
Giving
all or part of your inheritance away
Giving
money or property to individuals
Once
you claim your inheritance, you may want to give gifts of cash or property to your
children, friends, or other family members. Or, they may come to you asking for a loan or
a cash gift. It's a good idea to wait until you've come up with a financial plan before
giving or lending money to anyone, even family members. If you decide to loan money, make
sure that the loan agreement is in writing to protect your legal rights to seek repayment
and to avoid hurt feelings down the road, even if this is uncomfortable. If you end up
forgiving the debt, you may owe gift tax on the transaction. The gift tax may also affect
you if you decide to give someone a gift of money or property or a loan with a
below-market interest rate. The general rule is that you can give a certain amount each
calendar year to an unlimited number of individuals without incurring gift tax liability.
If you're married, you and your spouse can make a split gift, doubling the annual gift tax
exclusion amount per recipient per year without incurring gift tax liability, as long as
you and your spouse are U.S. citizens, sign and file a gift tax return (IRS Form 709), and
your spouse consents to splitting the gift. Giving gifts to individuals can also be a
useful estate planning strategy. For more information, see Federal Gift and Estate Taxes
(the Unified Transfer Tax System) and Lifetime (Noncharitable) Gifting.
Giving
money or property to charity
If
you make a gift to charity during your lifetime, you may be able to deduct the amount of
the charitable gift on your income tax return. Income tax deductions for gifts to
charities are limited to 50 percent of your contribution base (generally equal to adjusted
gross income) and may be further limited if the gift you make consists of certain
appreciated property or if the gift is given to certain charities and private foundations.
However, excess deductions can usually be carried over for five years, subject to the same
limitations. For estate planning purposes, you may want to make a charitable bequest that
can reduce the amount of estate tax your estate may owe. Or you may want to make gifts to
a charitable remainder trust. Such gifts may provide you with a tax deduction, while at
the same time providing an income stream for you, your family, or a charity (with the
remainder interest being held by the charity). For more information, see Charitable
Gifting.
