Most beneficiaries face many complex decisions — and potential tax consequences. These insights can help you avoid common mistakes and make more informed choices.
An inheritance can seem like a mixed blessing, coming as it often does after the loss of a loved one. At such an emotional time, it can be difficult to think through what you need to do to manage the gift. But even if your parents decide to give you your inheritance, or a portion of it, while they're still living — as parents increasingly prefer to do — you'll likely have many questions, says Kevin Hindman, managing director and wealth strategies executive, Bank of America Private Bank.
Don't wait until the decisions are urgent: Discuss in advance how the gift could help you pursue your goals.
— Kevin Hindman, managing director and wealth strategies executive, Bank of America Private Bank
If you expect to receive an inheritance at some point in your life, don't wait until the decisions are urgent. Consider discussing potential tax issues with a personal tax professional, and think about how the gift could help you pursue your goals. You might also want to talk with your parents about their hopes for your financial future — even how they might be planning to structure their future gift to you. Read the insights below for a better sense of how to prepare for the many issues beneficiaries can face.
A: It's not necessary to ask how much money your parents might leave you. Consider starting the conversation by asking about their values and what wealth means to them. That can lead to productive conversations about the role an inheritance could play in your financial future and what your parents' expectations might be. This sort of conversation also provides you with the opportunity to share your preferences and priorities. For instance, if there's a family business, or even a family vacation home, and you have no interest in owning either, be upfront about that. When everyone understands the expectations, the outcomes tend to be better for everyone.
A: You'll likely have some time before you receive the funds; depending on the complexity of the estate, the probate process, if applicable, generally takes at least six months to a year. Too often beneficiaries make large purchases or sweeping decisions that they later regret. Even paying off debt right away may not be in your best interests. For example, ask yourself: Does it make sense to pay off a mortgage at a rate below 3% if you could get a potentially higher return rate investing that money?
Instead, think about your competing goals and how you could manage your newfound wealth to help you pursue them. You can think about your goals in buckets: spending needs, short-term goals, long-term goals and philanthropy. How you allocate your inheritance to these buckets depends on your situation. If you have young children, for example, a portion could go toward college costs in the long-term bucket. But if you're looking at renovating your home or relocating, you can consider putting those funds into a short-term bucket to make sure they're easily available.
A: Not all inheritances are in cash; you might be named the beneficiary of a retirement account — or you could inherit the family home, for instance. If you've inherited a tax-favored account like an IRA or a 401(k) account, you'll be responsible for taking required minimum distributions (RMDs) as provided in the federal tax code. If you're an eligible designated beneficiary, or non-spouse designated beneficiaryFootnote 1, the RMD rules may allow you to distribute the account over an extended period of time, limited to 10 years after the death of the original account owner in some cases (depending on your age relative to the original account owner and certain other circumstances). The rules are complex and distributions have income tax implications. You should consult your tax professional regarding your specific situation. Assets in taxable accounts, by contrast, can be either liquidated or left in the account indefinitely. Again, you'll want to meet with a tax professional to decide the best strategy for you.
"Things can get more complicated when converting real assets such as a family home or business into cash, especially when multiple beneficiaries are involved," notes Hindman. If there are disputes over a will, it could take years for the issues to be resolved. In the best-case scenario, parents have worked with their advisor and estate attorney to construct a will or trust in such a way that its provisions account for the beneficiaries' desires — for instance, which child wants to keep the family home or work in the family business.
A: For tax purposes, an inheritance generally isn't considered income, but there are some exceptions. Typically, the estate will pay any estate tax owed, with the beneficiaries receiving assets from the estate free of income taxes (see exception for retirement assets in the chart below). As a beneficiary, if you later sell or earn income from inherited assets, there may be income tax consequences. And if you inherit certain tax-deferred accounts like a traditional IRA or 401(k) account, you'll pay taxes on your withdrawals, including RMDs, as ordinary income at whatever your rate is.
What's my tax liability?
| It all depends on the kind of assets you inherit |
| Type of asset |
How it's taxed |
| Cash and brokerage accounts |
Assets other than cash are subject to income taxes if sold for more than their value at the time of your loved one's death. |
| Real estate and tangible personal assets |
Real estate and tangible personal property are subject to income taxes if sold for more than their value at the time of your loved one's death. |
| Pre-tax and tax-deductible retirement accounts such as traditional IRAs and 401(k)s |
You pay your federal ordinary income tax rate on withdrawals; for non-spouse designated beneficiaries in many cases, the account must be emptied within five or 10 years of the original account owner's death depending on the circumstances. |
When it comes to taxable accounts and other assets like real estate, there's the possibility you'll owe no income tax, because the cost basis of the asset gets stepped up (or down) to current fair market value upon its owner's death, thereby wiping out any taxable capital gains on appreciated assets, says Hindman. Keep in mind that if you inherit an asset that provides income — say, a trust that pays out annually — it may put you in a higher marginal tax bracket.
A: Whenever your net worth changes, you should update or revise your estate plan. You may need to consider how to protect certain newly acquired assets — for instance, a family home or business that's been passed down to you that you want to someday go to your children.
Ask yourself: if something happens to me, how will the assets flow to the people I care about? A trust might be one way to accomplish that aim, but a tax and legal advisor can help you determine what's needed to contribute to your beneficiaries' futures.
Footnote 1 An eligible designated beneficiary (EDB) is a surviving spouse, a disabled or chronically ill individual, an individual who is not more than 10 years younger than the decedent, or a child of the account owner who has not reached the age of majority. Distribution rules differ based on the account owner's date of death; whether the beneficiary is an EDB, a designated beneficiary or neither; and whether the original account owner died before or after their required beginning date for required minimum distributions.
Trust, fiduciary, and investment management services are provided by Bank of America Private Bank, a division of Bank of America, N.A. and its agents, Member FDIC, and a wholly owned subsidiary of Bank of America Corporation.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decision.
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