With Sandra Block, Senior Editor at Kiplinger’s Personal Finance
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To learn about the best ways to handle an inheritance, Steve spoke with Sandra Block, Senior Editor at Kiplinger’s Personal Finance. Sandra recently wrote an article all about the smart ways to handle an inheritance. Here’s the advice for heirs that she shared with Steve.
More than half the population eventually receives an inheritance of one kind or another—either money, stocks, or real estate, although the amount varies greatly. According to a 2013 study done by the Federal Reserve, the average bequest for those among the wealthiest 5% in the U.S. was $1.1 million, while for the bottom 50% it was $68,000. But whether you receive a large or small inheritance, it’s important to know how to handle it wisely to minimize taxes and maximize your benefit from the money.
Don’t Quit Your Day Job
Sandra’s first piece of advice for anyone receiving an inheritance is not to make any major decisions—such as quitting your job—for at least a year. Instead, first, take the time to think things through and do some smart financial planning with some expert financial advice if needed on how to best handle the money. A lot of people who receive a sizeable inheritance, say, a million dollars, make the mistake of thinking they’re automatically set for life. The truth is that you can probably spend a million dollars a lot faster than you think you will.
If you want to make that inheritance money last and receive maximum benefit from it, do your future self a favor by holding off and showing some restraint in how you handle it. Things can get complicated, as inheritances come in many forms other than just cash, such as retirement accounts or real estate.
Dealing With Inheritance Taxes
One thing you should pay attention to with any inheritance is how much you may owe in taxes. Most people don’t have to worry about federal estate taxes anymore because the exemptions are so high; but depending on the state you live in, you may have to pay state estate taxes. You can face a big tax hit if, for example, you inherit an IRA or 401K account, since the money hasn’t previously been taken out and taxed. And the fact is that retirement accounts like those make up a lot of the inheritances that people commonly receive.
Handling An Inherited IRA
If you inherit an IRA account, what you do with that money will have a big impact on how much you’ll have to pay in taxes. If your parent or whoever left you the money did the right thing and named you as a beneficiary, you do have options that can reduce your tax liability. Of course, you can choose to withdraw all the money from the account, but then you’ll have to pay taxes on it. Cashing out a $500,000 IRA account will immediately put you in a high tax bracket.
In order to avoid a potentially large tax bill, you can transfer the money to an inherited IRA. For this to work, you have to make sure you transfer the money directly to the inherited IRA. If you withdraw the money and then put it into the new account, you’ll still owe taxes on the whole amount. Once the money’s in the inherited IRA, you’ll still have to take required minimum distributions every year, but those will be based on your age and life expectancy. You can always take out more if you need to, but by just taking out the minimum amount, that money can continue to compound and grow so it’ll be there for when you retire.
If you happen to inherit a Roth IRA, you should be very thankful that you got such a tax-efficient inheritance. As long as whoever left you the Roth IRA had it for more than five years, you won’t have to pay any taxes on the money you take out. You can also opt to transfer money from a Roth IRA to an inherited IRA. You’ll still have to take out at least minimum distributions, but you won’t owe any taxes on that withdrawal.
Stocks are another common type of inheritance. Inheriting a stock portfolio offers one major tax benefit up front: for tax purposes, when you receive the stocks, they’re valued at their price when you inherited them. That means that even if, say, your parent bought a bunch of stock at $50 a share and the shares are now worth $100 each, you’ll only have to pay taxes on any gains beyond that $100 price. You won’t owe any taxes on the gains from $50 to $100 a share that occurred before you inherited the stock. The IRS refers to this as valuing the stocks on a “stepped up” basis.
If you receive an inheritance of stocks, it’s a good idea to review them and see if they fit in well with your own investment portfolio and financial planning and if they’re appropriate for your age and risk tolerance. Stocks you inherit may not consist of a well-diversified portfolio. It might be a good idea to sell them and invest the money in a broad range of low-cost ETFs, something that gives you really good diversification. That way, you’ve lowered your risk and you don’t have to worry about trying to pick individual stocks.
Real Estate Inheritance
If you happen to inherit real estate, like the house your parents lived in, you again get the tax benefit of the property being valued on the “stepped up” basis. That can mean a sizeable amount of tax-free home equity if your parents bought the house many years ago and it’s appreciated a lot in value. If you sell the home, you’ll only owe taxes on the difference between the sale price and the home’s value at the time you inherited it.
You’ve got basically three options with inherited real estate. You can move into the house yourself, you can sell it, or you can rent it out for regular income. If you think about going with that last option, you should first familiarize yourself with all the responsibilities a landlord has. If the house is older, it may need some significant repairs before you can successfully rent it out. Again, it’s just a good idea to take some time, evaluate your inheritance, and think about the smartest way to handle it.
To learn more about smart ways to handle an inheritance, check out Sandra’s article at Kiplinger’s Personal Finance.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: According to a 2013 study by the Federal Reserve Board, the average request for the wealthiest 5% of US households was 1.1 million where we’re talking about money left behind to the next generation. So, for the top 5% it’s about 1.1 million, for the next 45%, it was 183,000, and for the bottom 50%, it was 68,000. So, whether you’re going to get a small or large amount, we’re going to talk about smart ways to handle an inheritance, and joining me is Sandra Block, Senior Editor at Kiplinger’s Personal Finance. Welcome to the show, Sandra.
Sandra Block: Thank you for having me.
Steve Pomeranz: We’ve 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. So if we’re one of the lucky ones to receive this bequest, what is your advice, Sandra? I know actually you wrote your advice was don’t quit your day job. Why do you say that?
Sandra Block: Because a lot of people overestimate how much money they actually have and how much it would cost them if they stopped working, especially if you’re in your 30s or 40s, even let’s say you inherit a million dollars, which seems like more money than anybody ever has in one place.
Steve Pomeranz: Right.
Sandra Block: But if you stop working, you’re gonna live another 50 years. And people blow through that money really fast.
Steve Pomeranz: Yeah.
Sandra Block: And the other thing that we often tell people is whether you’ve got a small or a large bequest, it’s usually a good idea not to make any major decisions for a year. Because you may be dealing with some grief if it was somebody you loved. And it also just takes that long to sort of get together a team and make smart decisions about your money so you don’t end up spending it, quitting, giving it to somebody who’s going to scam you or something like that.
Steve Pomeranz: Yeah, that is really terrific advice, so let’s just kind of repeat that, maybe rephrase it a little bit. The idea is if you’re a 30 something year old and you see a million bucks as money, the vast majority of people have never seen and dreamed about having, and so this million bucks, it just seems to last a long time.
But the fact is, like Sandra says, it can go pretty quickly. And the fact is that you’ve gotta think of the future, and have some of this money leftover to take care of you. So it’s a balance between now and the future, and doing your future self a favor by holding off and showing some restraint.
So, complicating the matters when it comes to estates, it’s one thing if you get a million dollars in cash but a lot of time estates are made up of real estate or they have retirement savings accounts, which are different than kind of cash accounts, different than bank accounts and brokerage accounts. There’s life insurance plans. How would you start to navigate through all of these different kinds of possibilities?
Sandra Block: Well, one thing you really have to pay attention to, and again this is another reason not to quit your day job, is how much that you will potentially owe in taxes. Most people don’t have to worry about federal state taxes anymore.
The exemptions are so high that only the very wealthy will have to pay them. In some states, you may have to pay an estate state tax. But the real tax hit comes if you inherit an IRA or 401K money that basically has not been taken out and taxed. And that’s really going to represent a lot of the amounts of money that people do inherit, because that’s how people save these days, and that’s often the bulk of people’s retirement savings.
Steve Pomeranz: True.
Sandra Block: If you inherit an IRA, what you do with that money will have a big impact on how much you’ll have to pay taxes on it. You will have to pay taxes on it. But if you do it if it, if your parent or whoever left you the money did the right thing and named you as a beneficiary, you do have options that will reduce the amount of taxes that you have to pay with the I.R.A.
Steve Pomeranz: Yeah, let’s talk about those. So first of all, you can take the whole amount if you want to. And you will-
Sandra Block: Yes, and then you will pay taxes on the entire amount.
Steve Pomeranz: Yeah. So let’s say it’s $500,000. You’re gonna pay taxes on 500, that’s gonna put you in a pretty high tax bracket. So you’re gonna be paying taxes at that level. So a lot of that is just gonna go wash away in taxes. What’s another choice?
Sandra Block: Another choice would be, if it is in an IRA, is to put the money in an inherited IRA. And it’s very important that you have it transferred directly to the inherited IRA, don’t take the money out. It’s not like you can take the money and then write a check. You have to have it direct transferred.
You put it in an inherited IRA, you’ll still have to take required minimum distributions every year, you can’t just let it sit there, but the R&Ds will be based on your own age and life expectancy. So you won’t have to take out as much. You could always take out more but you can take out, by taking out just the minimum, that money can continue to compound and grow, and it will be there for when you retire.
Steve Pomeranz: Yeah, so if you’re 70 years old and your life expectancy is what, at 14, 20 years or something like that and you’ve gotta take this money out, it’s gonna be less years, so if you divide those fewer years into that amount, the amount you’re actually pulling out is greater.
If you’re 30 years old and you’ve got 50 years to calculate before you need this money, you divide that amount by 50, and the amount per year you pull out is much, much smaller. That’s why age makes a difference, and you wanna absolutely calculate all of those things. What about a Roth IRA? What if I get a Roth IRA?
Sandra Block: Then you should be very grateful to your parents for leaving you something so tax efficient. Because you don’t have to pay taxes on a Roth IRA. So what options will just be to, if you had a pressing financial obligation you could just take that money and use it. But the other option is that you can also put this in an inherited IRA. The IRS won’t let you let it sit there forever, you still have to take distributions. Why? You don’t have to pay taxes on that money when you take it out. So an inherited Roth gives you a lot more flexibility than traditional hiring Right
Steve Pomeranz: Usually they don’t have nearly as much money in them as regular IRAs because of limitations and other things, but whatever that amount is if they’ve had it for more than five years all the distributions are tax-free. There’s another aspect to look at here. So a lot of people come to us and they have stock portfolios that their parents, I will say their elderly parents had, and they inherit the stock portfolio. Well, first of all, the taxes are pretty good because there is a thing called a stepped-up basis meaning that you price those securities at the date of death.
Even if they paid something significantly less 25 years ago, so therefore, if you’d sold them on the date of death, or based on that, rather, at the same price, you would pay no tax. So that’s good, but here’s the thing that I wanna talk about with you, Sandra. I often see that children who receive these inheritances hold on to the investments that their parents made for themselves due to sentimental value. Do you have any comment on that? I surely do, but I wanna hear you first.
Sandra Block: [LAUGH] Yeah, I think that it does happen, but I think it can really be not financially savvy because what your parents invested in may be very different. And what oftentimes people inherit is company stock. Maybe your dad worked for G.M. Or I.B.M. Or something like that and invested in company stock and has a lot of that. Well, that’s not really going to diversify your portfolio.
And because of the step up in basis it does give you an opportunity to reinvest that money in something that’s more appropriate for your own age and tolerance and all those other things. So I think even though you might have some sentimental attachment to it, you should take advantage of the tax benefit to reinvest that money in something that’s more suitable for you.
Steve Pomeranz: Good point. The other thing too is that your parents come from a culture, depending on how old they were, of buying individual stocks. And what you’re seeing is at the end of their life, these are the stocks that have survived. Think of a garden, right, and certain plants survive, other plants don’t.
And if you’re smart, you pull the weeds out and you keep the healthy flowers. Well, the healthy flowers are the stocks that remained in the portfolio. But they’re used to buying individual stocks. These days, you really have to have a special know-how in order to do that successfully. So it’s probably a better idea to take that money and invest in a broad range of low-cost ETFs or something that really gives you good diversification, and now you don’t have to be a stock picker and take the risk that if something goes wrong you’re really not minding the store, you could lose a significant portion of it.
Sandra Block: That’s right. And again, I think if you said some of the stocks that might have been really beloved by your parents may not be as beloved by you.
Steve Pomeranz: Right.
Sandra Block: I think the other thing a lot of people might end up inheriting in a much more conservative portfolio than suits them, maybe your parents have most of their money in bonds because they didn’t want to take risks.
Steve Pomeranz: That’s right.
Sandra Block: So if you are a younger person, you’d rather reinvest that money into something that has more growth potential.
Steve Pomeranz: Yeah, yeah. Bonds would be a very bad idea for a 30-year-old, a 35-year-old, because you’re going to get 2%, 3% maybe for the foreseeable future, and stocks, over a long period of time, have shown to do much better. All right, what about real estate? That could get kinda complicated, it’s not as easy to sell real estate as it is to sell some kind of a stock or mutual fund.
Sandra Block: That’s right. You do get the step up there, too, so that could be really beneficial to say, somebody whose parents own a house on one of the coasts that they have owned for years and years and years, and it’s worth way more than they paid for it, you’d get that great advantage of not having to pay taxes on all the gains. But, again, as you said, it’s a much more difficult asset to unload than stocks or funds, and emotion gets involved there too.
Steve Pomeranz: Yeah.
Sandra Block: People don’t wanna sell the house that they grew up in. But the planners I talk to said that you really gotta be careful about thinking you’re going to keep the house and rent it out. Because that’s a lot of work, it can cost a lot of money. Just don’t underestimate how hard that might be.
Steve Pomeranz: It’s complicated, I mean we’re talking about bricks and mortar. We’re talking about things that depreciate physically, that depreciate. These are atoms and atoms can depreciate. [LAUGH] So as opposed to digits is what I was trying to say.
Sandra Block: [LAUGH]
Steve Pomeranz: So there’s money [LAUGH] to maintain the home
Sandra Block: Right.
Steve Pomeranz: You have to pay the mortgage, and you may have to fix the houses up for sale, you have to keep it at a certain level in order to keep it viable in the market, it’s much more complicated. So they have to be treated significantly different. Sandra, we are out of time. We’re talking today with Sandra Block, Senior Editor of Kiplinger’s Personal Finance. We’ve been talking about what to do if you get an inheritance, some of the things to think about. You can go to the Kiplinger’s site and Google and search for Sandra Block and she’s got a great article on that.
To hear this and any interview again, if you have any question about what we just discussed, remember go to our website, stevepomeranz.com, and ask a question, we love to get your questions. Sign up for a weekly update where you’ll hear about all of our live events and important topics we’ve covered this week. And it’ll go straight into your inbox every single week, that’s stevepomeranz.com. Sandra thank you so much for sharing with us today.
Sandra Block: Thank you for having me.