In this episode, I discuss the potential pitfalls to watch out for when inheriting assets from a parent. Receiving an inheritance isn’t the same as maximizing an inheritance, as you could lose a significant portion if you’re not prepared.
More specifically, I discuss:
- What are common types of assets that are passed down to the next generation?
- What are the common pitfalls to watch out for when inheriting property?
- How should assets be titled before they are passed down?
- What impact do trusts have on an inheritance?
- How do taxes work when inheriting assets?
- What are the common pitfalls to watch out for when inheriting retirement accounts?
- What are the common pitfalls to watch out for when inheriting non-retirement accounts?
Resources From This Episode:
The Key Moments In This Episode Are:
00:00:00 - Introduction and Importance of Understanding Inheritance
00:00:57 - Projected Increase in Inherited Wealth
00:02:12 - Parental Financial Planning
00:03:36 - Common Types of Inherited Assets
00:05:27 - Pitfalls of Inheriting Property
00:14:28 - Considerations for Inheriting Property
00:15:48 - Retirement Accounts and the Secure Act 1.0 & 2.0
00:19:37 - Tax Considerations for Inherited Retirement Accounts
00:21:28 - Handling Non-Retirement Investment Accounts
00:25:35 - Importance of Understanding Inheritance Planning
The great wealth transfer is upon us. And many of you have aging parents from the Silent Generation, or maybe the first of the Boomer generation, who are passing down more assets than ever in our nation's history. If you know or think you may be the recipient of an inheritance of any size, it is crucial that you understand how that inheritance will mesh with your own situation and how to avoid common pitfalls. Otherwise, you may end up sharing more than you need to with the IRS and potential state tax authorities.
Hello, and welcome to Retired-ish. I'm your host, Cameron Valadez, Certified Financial Planner, and today we are going to discuss how a potential inheritance from your aging parents isn't all icing on the cake or a ticket for a shopping spree. If you're someone who has made significant progress towards your own life and retirement plans and you want to be efficient with your family's hard-earned money, this episode's for you.
A study done by the Boston-based financial research firm Cerulli Associates projects that about $84.4 trillion will be passed to families and charities by the year 2045. That's a lot more so than ever before in our nation's history in that time frame.
If you are or will be part of this statistic, you're likely to fall into either one of two camps. The first is the big spender who probably already has the inheritance earmarked for one to several big purchases, and no offense if this is you. Or the second is the one who has never relied on any such inheritance and has done a lot of financial planning thus far, and the inheritance will either lighten up the stress or allow you to live a more fruitful life while also maintaining generational wealth for your kids and grandkids. However, in either case, I think it's safe to say that you'll want to make sure you don't make simple mistakes that end up costing you money and cutting the inheritance in half.
Some examples of this may be getting caught up in the probate process, fighting with siblings, and, most importantly, giving away more than you needed to in taxes. These are the things that will catch you off guard, and oftentimes it will be too late to remedy the situation. You can help prevent some or all of these things from happening if you prepare ahead of time. The best-case scenario would be to help your aging parents structure their own finances appropriately while they are still alive. Don't think for a second that Mom and Dad have been around the block and definitely know what they're doing just because they have a lot of money or assets.
It is all too common for adult children to assume that everything has been set up appropriately simply because Mom and Dad had something like a will or a trust. This especially holds true if your parent is entering a phase where they need care either at home or in a facility. In these situations, you're often already helping them make decisions about the end-of-life care itself. So you should help them make sure that their finances are structured according to their wishes as well.
Okay, so when I say inheritance, what exactly am I referring to? What are the common types of assets that will be passed down that make up this multitrillion-dollar number? Well, the most common asset to inherit, of course, is property. Whether that be Mom and Dad's residence or their residence, as well as a vacation home or some other investment rental properties. Properties have their advantages when inherited, but they also have many pitfalls that you'll want to be mindful of, which we will get into shortly.
The next common asset, I'd say, is a retirement account. So an IRA or a 401(k), for example. There are currently trillions of dollars stuffed in retirement accounts due to their tax-deferred nature of liquidity and the explosive growth of the stock market over the last decade plus. These assets will provide a little more flexibility than, say, a property, but they will generally have more tax ramifications depending on your own current circumstances. Due to some of the retirement and tax law changes as of 2020, careful planning needs to be considered here.
The third most common asset to be inherited is one or more nonretirement accounts. Examples of these accounts could include trust accounts, transfer on death or payable on death accounts, also known as TOD or POD accounts, non-qualified annuities, and last but not least, cash, CDs, or bank accounts. The majority of these assets typically have the most liquidity and the easiest access to because, again, they're easy to get to and usually have preferential tax treatment. Another thing that would fall into this category would be life insurance proceeds, which are typically tax-free cash payments to the beneficiaries. As I said, if you are to receive an inheritance, these are the most common types of assets that you will likely have some mix of, and you'll want to know how to get them to play nice in the sandbox with what you already have.
I know it sounds weird that inheriting money can actually cause problems, but believe me, it does. This is even more the case if you stand to inherit Mom and Dad's business, which can lead your entire life in another direction, for better or worse. But I digress. We will save that for another episode. So now that we understand what's out there, I want to get into the most common costly issues or pitfalls I see arise when assets are passed to the next generations and how to try to avoid them.
And I want to start with property. And this is where most of the inheritance mishaps can happen. The first thing you and your aging parents will want to understand is how to title their property according to what they want to have happen with it. As you likely know, properties have what are called deeds that can be titled in different ways. Typically the deed will be in their name or maybe joint with their spouse.
If a deed is titled Joint with Rights of Survivorship, for example, the property will pass directly to the surviving joint owner upon the death of the other owner and, therefore, typically not trigger any probate. The common issue, however, is that when one parent precedes the other, the surviving parent will often leave the deed in their own name alone. Then when they pass, the property often does go to probate, which can be a very lengthy and expensive process in most states. This, of course, will eat into the value you may inherit at the end of the process. If your parents have a trust, on the other hand, the estate attorneys who drafted that trust will often help title the deed in the name of the trust, which avoids probate and helps ensure the property passes to the intended heirs.
However, you need to understand that the deed needs to actually be in the name of the trust. Sometimes people get a trust made, and they fail to fund the trust, meaning the property or certain other assets never actually get put into it, and therefore the trust fails to work properly. Just because a trust is made doesn't mean everything is necessarily taken care of. So double-check to make sure that the trust is funded properly if one exists. If one or both of your parents are still living, you can help them look into this.
Another common pitfall with this is when there is currently one surviving parent who trusts you or one of your siblings to help them with their finances and wants to put you or them on the deed while your parent is alive for whatever reason. This can cause a myriad of issues. The first is that if you are put on the title with a parent, they have technically gifted you partial ownership of that property. This means that regardless of what their will or trust says when that parent passes, the property will typically go to the other joint owner on title. So, in this case, it would be you or maybe your sibling. This causes other siblings to get disinherited.
The second major issue is that when you are gifted property during their lifetime, you take on a share of the original owner's tax basis and value of the property. If, instead, you inherit the property after their death, you typically will receive what is called a full step-up in tax basis. This can cause major tax implications if you later decide to sell the property, and therefore you will receive less after taxes than what the property was worth at the time of the sale because you may have a taxable capital gain.
Here's a hypothetical example. Mom's home is worth $1 million. Her tax basis in the home, or essentially what she bought it for years ago, plus any improvements she's made, is $300,000. If she puts you on title with her, your basis is now 150,000, and her basis is 150,000, which equals the $300,000 total tax basis. When Mom dies, you will receive a step-up for her portion of the value, which is half of the $1 million. So $500,000.
You would then add that to your current basis, which again is $150,000. This means that your new total tax basis in the property is now $650,000. Therefore, if you decide to sell the property for $1 million and not factoring in any other selling costs, you would theoretically have a $350,000 capital gain costing you tens of thousands in taxes at the federal and possibly the state level. In this case, probate was avoided, but at a very hefty price tag.
Not to mention your siblings, who aren't going to be very happy knowing you just inherited Mom's house entirely, even though her will said otherwise. This is a costly mistake that can be avoided by planning ahead. Now, if Mom didn't put you on the title and you instead inherited it after her death, you would theoretically get a full step-up in tax basis to the value of the property at death. For example, your basis would be the property's value at death $1 million. And if you immediately turned around and sold it for $1 million, you theoretically have no taxable gain at all, and the full inheritance is preserved.
As you can see, property titling is very important and not to be overlooked, but sadly, this is all too common. Now, you may be thinking that instead, you simply wouldn't sell any property and instead turn them into passive rental properties. This may be a good idea, given your situation and goals, but there are many more factors you'll want to take into account. One such consideration is in states like California. In California, we have what is known as Prop 19, which can greatly affect the property taxes on inherited property.
While I won't get into the nitty-gritty of this entire proposition, you'll want to understand how this can impact you. In general, when an adult child inherits property, whether it is in a trust or not, the property value for property tax purposes will be reassessed at its current value, which is usually much, much higher than the value it was based on when Mom and Dad were alive, especially if they've owned the property for decades. Now. It's also worth noting that there is a limited exclusion available depending on what you do with the property as well. But in general, if you or another sibling do not personally move into the property and use it as your own residence within a year after taking the title, it will generally be reassessed.
So if you plan on holding it for rent, instead, you are likely to incur much larger property tax bills going forward than Mom and Dad had ever paid. Again, there are many more nuances and rules when it comes to Prop 19, but that's beyond the scope of this episode. Your attorney, financial advisors, or tax professionals should advise you further on this if this is your situation. The ultimate point is that if your parents were receiving, let's say, $2,500 a month in net rental income after expenses and taxes, that doesn't necessarily mean that you will as well if you decide to rent it out.
You will need to consider these property tax changes as well as other expenses, current market rents, and your tenants. A lot of times, we see that elderly parents may have gotten lucky with great long-term tenants, so they didn't have to spend a lot of time and money constantly turning the home over to new tenants and making many improvements. In addition, sometimes elderly parents choose not to increase rents on a consistent basis. This means that the rent they are charging may be far behind current market rates. And if you go in and raise them to fair market rates, you may lose these long-term tenants and have to start over with a new tenant or multiple new short-term tenants.
The point is that this costs money and, more importantly, your time, which is priceless. So consider these things when deciding on what's best for you and what you want out of your life moving forward. Do a thorough financial analysis of how a rental property will work in your situation and how it will affect your own tax situation, and go from there. If you decide to rent the property, you are also able to get some other great tax deductions, such as depreciation. But again, do the analysis first.
Sometimes the property tax changes and other headaches will outweigh the benefit from the potential depreciation deduction. Now, the last pitfall that you'll want to be mindful of when the property is involved is when there is more than one child inheriting the property. No one wants to fight with their siblings, and I'm sure your parents want you to get along and want to be sure that everyone is taken care of. Usually, when they do their estate planning, they intend to avoid family squabbles and arguments over what Mom and Dad would have wanted. But unfortunately, it doesn't always work out that way.
One of the most common ways that parents pass different assets to the next generation is by having all of their kids inherit their fair share of each of the different assets that they own. So, for example, say they have a home, a rental property, a retirement account, and, say, a trust account. They will set up their beneficiary designations and their trusts to say that John, Joe, and Jane each will get 33% of everything, 33% of each home, and 33% of each account. This can pose a major issue, especially with property. The reason is because one child may want to move into the property or maybe rent it out, while maybe the other two want to sell it.
Or maybe two of you want to move into it with your family. And obviously, that can't happen. So what now? In these cases, you're going to have to hash it out with your siblings, and thus the fighting begins. Now, when it comes to the finances, things can get even tougher.
Let's say that you all agree on letting one sibling move into the home and use it as their own. The sibling that moves in has to essentially buy you and your other siblings out. A lot of times, this means refinancing the home to get equity out to pay both of you off. However, this may not be feasible at that time for the sibling moving in. Think about it.
What if interest rates are extremely high and the payment would be far too large for them to manage financially? What if they can't even qualify for the refi due to poor credit and income? The list goes on. This is a prime example of why these things need to be considered well beforehand to be sure Mom and Dad's wishes are honored. And so one or all of you don't end up getting hurt financially or ending up less well off than the others, which will cause family tension.
If you all decide, let's say, to rent the property, do you really want to be a landlord with your other siblings? How likely is it that everyone contributes their fair share of the time? What if you are the one that lives closest to the property, and you're going to be the only one who deals with it, while your other siblings just sit back and collect their share of rent? These are some examples of the nonfinancial hangups that you'll want to think about first. Okay, moving on from properties, let's now talk about retirement accounts such as IRAs and 401(k)s.
Chances are, Mom and or Dad have retirement accounts. These accounts typically fall into two camps pretax and tax-free, pretax being the most common. Pretax money is typically found in traditional IRAs or Rollover IRAs and employer plans such as 401(k) plans. The retirement account with tax-free benefits is known as a Roth IRA and even a Roth 401(k).
Now, the rules and regulations surrounding these accounts and how they are treated when inherited by someone other than a spouse have changed drastically since 2020, when the Secure Act was passed. The new legislation changed retirement and tax laws that had been in effect for decades. Then the Secure Act 2.0 was passed, with even more changes shortly thereafter, just recently in 2022. It used to be the case that when a beneficiary other than a spouse, such as an adult child, inherited a pretax retirement account, they could what we call stretch the benefits out over their own life expectancy, per the IRS.
This meant that if you wanted to continue to invest that money and let it grow over your own lifetime to help you accumulate more wealth, you could do so and only be required to withdraw relatively small amounts each year over time. The other benefit to doing this was that you weren't taxed on any earnings or gains in the inherited account each and every year when they were incurred. Only the amounts that you withdrew, known as required minimum distributions or RMDs, were subject to taxes. Roth IRAs, on the other hand, didn't even have RMDs. So once you inherited one of those accounts, you could do essentially whatever you wanted with it.
However, now things have changed for the vast majority of adult children who are inheriting these types of accounts. Now, with few exceptions, most adult children have to abide by what we refer to as the ten-year rule. This rule states that the inherited account must be completely withdrawn by December 31 of, the 10th anniversary year of the original owner's death. When the law originally passed, it essentially said that there is only one of these required minimum distributions, and that is essentially the full account balance that needs to be pulled out or withdrawn from the account and taxes paid by the end of that ten-year time frame. This obviously kills a lot of flexibility with these accounts because now you are forced to make withdrawals and add this income to your own income and pay taxes on it somewhere within those ten years. You're not able to stretch it over your lifetime anymore.
However, in 2022, to make things more complicated, the IRS came out with additional guidance on what they really wanted when that law was written, and that is that if the original owner, so your parent, in this example, had started taking their own required minimum distributions before they passed, you as the adult child, would have two rules to follow. The first being still that the account must be empty in ten years and that you will have an annual minimum amount that you must take out in years one through nine based on your own life expectancy per the IRS. Then they said that if your parent had not yet reached the age where they had to begin taking their own required minimum distributions and passed, then you just have to drain the account by the end of year ten, and you're not required to take annual amounts in years one through nine. Roth accounts, on the other hand, no matter when the deceased passed and whether or not they were taking their own RMDs, just need to be drained by the end of year ten. There are no smaller RMDs in years one through nine.
Why do I share all of this with you? Because due to these new rules, your own tax situation is likely to get overhauled, especially if you receive large pretax retirement account balances. Not to mention because of all of the recent changes and guidance from the IRS, there are a lot of professionals out there who still don't understand the rules fully as they are today. So it's important that you at least have a general idea so that way you can work with them on these potential issues. So how do you determine how much to take and when?
Well, this depends largely on your personal situation and, most importantly, your tax situation. Understand that when you take money from these pretax accounts, the amount is taxed as ordinary income. So if you wait all the way until the last year in year ten and decide to take a large lump sum of the entire account balance, you could find yourself in the highest of tax brackets and end up giving the tax authorities half of your inheritance. This is why integrating these situations into your own finances is so critical. Depending on your tax situation year in and year out, you may find more opportune ways to get the money out while giving the tax authorities as little as legally possible in taxes.
I will discuss more strategies around this in the next podcast episode, where we are going to go over inheritance strategies. Lastly, I want to discuss things to watch out for when it comes to any of those other investment accounts that aren't considered retirement accounts. Oftentimes parents had savings above and beyond their property and retirement accounts. This is usually due to the fact that retirement accounts have maximums each year on how much you can put into them. So if your parents had any extra dollars to save, they oftentimes directed them into these other types of accounts.
Or maybe they sold something like a property during their lifetime and invested the proceeds. This money is typically found in an investment account that's either in their name or jointly held with their spouse. A lot of times, these accounts are titled, In Trust, if they create a trust. Now, if a trust is involved, the rules are similar to the rules of property that I mentioned earlier. These accounts actually had to have been titled in the name of the trust to be passed down according to what the trust says.
If there was no trust, beneficiaries should have been labeled on the actual account documents to dictate who the money goes to. Now, these beneficiary designations supersede any wills or trusts that may exist, and they also help avoid probate on the money that's held inside. When beneficiaries are listed on these types of investment accounts, they are typically referred to as transfer on death or TOD accounts. Therefore, if your parents have assets in these types of accounts, it's important to help them make sure that they are titled properly and beneficiaries are labeled. Otherwise, you may find yourself in a situation where Mom and Dad have a trust that says you and your siblings split the money 50-50. But the investment account was never titled in the name of the trust, and only one of you is listed as a beneficiary. Or worse, neither of you is listed as a beneficiary, and so only the one listed as a beneficiary gets all of the money, or if none are listed, it goes to probate. As you already know, neither of these situations is good.
Now, when it comes to taxes, these accounts work similarly to property. If you are put on as a joint owner with Mom or Dad during their lifetime, they have technically made a gift to you, and you will take ownership when they pass first before any of the labeled beneficiaries do. In addition, you can run into the same tax basis issues we talked about earlier as well. If, however, beneficiaries are labeled properly, and titling is done properly, these assets should pass probate-free and rather easily. But don't assume that you don't need to be paying close attention and that you're out of the woods just yet. The reason I say this is because when the assets in these accounts pass to you, they should receive that full step-up on a tax basis or cost basis that we talked about earlier.
However, sometimes the custodian, which is the entity or the company holding the investments and sending you the statements and the tax documents like 1099s, sometimes they don't actually process that step-up properly. Yes, I know you'd think that they would do things correctly 100% of the time, but of course, humans and even computers can make mistakes. I have personally seen this happen a handful of times, and the worst part about it is that the beneficiary often doesn't even notice. Then when they go sell the investments at some point in the future, there is a very large tax bill waiting for them. Therefore, when these accounts get turned over to you, you need to make sure that the proper step-up has occurred on the investments inside of the account.
Work with your professional advisors to make sure that this gets done. It can be the difference between tens of thousands of dollars going to the IRS and any potential state tax authority. All in all, while an inheritance may be a nice windfall for you in your own personal situation, there are many things that you'll want to be prepared to encounter. Please don't make the assumption that your CPA attorney or other advisors have everything handled to the tee. Now I'm not at all saying that they don't know what they're doing. It's just that sometimes things slip through the cracks and can eat well into your inheritance and destroy what your mom or dad may have intended.
Be aware of these things so that you can work with your various advisors. This will help them help you. As I mentioned before, stay tuned for the next episode, where we are going to continue this conversation and go over some actual strategies to consider with the various assets that you may inherit and how to incorporate them into your own plans for tax, estate, and investment efficiency.
Now that does it for today's episode. If you have more questions regarding inheritance planning or a particular strategy that wasn't tackled on today's show, feel free to ask me a question on Retiredishpodcast.com. You can go to the Ask a Question page at the top. I will also include a link in the show notes for today's episode and ask a question. I will do my best to answer it in a future episode. And if you have a minute and find this information actionable and insightful, and you want to stay up to date on the latest useful retirement planning content, please subscribe to or follow the show on your podcast app.
If you'd like to learn more about the rules and strategies discussed in today's show, you can find the links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/28. There you can also sign up for our monthly Retired-ish newsletter, where each month we discuss money and emotions, investing, tax reduction strategies, estate tips, Medicare and Social Security, long-term care planning, and even a brief discussion about the current markets in layman's terms. We always include something actionable in our newsletters so that you can implement things right away, such as how-to guides and other simplified strategies. Again, this can all be found at retiredishpodcast.com/28. Thanks again for tuning in and following along. See you. Next time on Retired-ish.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.
In addition, if you are required to take a required minimum distribution, RMD, in the year you convert, you must do so before converting to a Roth IRA. Investing involves risk, including the potential loss of principle. No investment strategy can guarantee a profit or protect against loss. Past performance is not a guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, and bonds are subject to availability and change in price. Government bonds and treasury bills are guaranteed by the US government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value.
Treasury inflation-protected securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes a more sensitive to price declines associated with higher interest rates.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gain tax could apply.
Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.
Asset allocation does not ensure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.