Financial Strategies to Consider When Inheriting Money

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If you find yourself in a position where you are to receive some sort of inheritance, no matter how big or small, you'll want to be aware of how to incorporate it into your own life. Otherwise, you may later realize you've wasted a lot of time and money. Money is emotional and it's easy to make hasty decisions that may not be the right decisions. Understanding your options ahead of time is paramount during the process of taking on a loved one's life savings.

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Hello and welcome to Retired-ish. I'm your host, Cameron Valadez, Certified Financial Planner, and today we are going to piggyback off of last week's discussion regarding costly pitfalls to watch out for when coming into a potential inheritance of any size, big or small. Today we're going to add to that by going over some financial strategies that you might consider looking into in order to make the most of what you've been fortunate enough to receive by incorporating an inheritance into your own life plans for tax, estate, and investment efficiency.

Many of you reaching your own retirement years that are also fortunate enough to receive a financial windfall from a parent, for example, are often left wondering what to do with this new responsibility. There are so many options out there and ultimately you may be wondering what you can do to put yourself in a better situation for your own mental health as well as financial health. My goal is to explain some of the things you'll want to think about when planning your own future.

Now, before we dive in, I want you to know that most, if not all, of the strategies discussed today will require you to work with your various professional advisors such as attorneys, CPAs, or enrolled agents, and maybe financial planners as well, or your parents own advisors. Each have different expertise on certain subjects. And the key is that you don't necessarily need to understand all of the detailed ins and outs. My goal is to share some of these potential strategies with you so that at least you've heard of them and you know what to bring up in your meetings with your professional advisors to help save you time and money.

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So let's dive in. First, let's go over a few strategies to consider when inheriting property, which seems to be the most common asset that is passed down to the next generation. As I mentioned in the last episode, you'll want to determine how many other individuals, if any, are also inheriting the same property you are. Then, depending on whether or not you received the property from a trust and what that trust specifically says, you may have various options on what can be done with the property. Now, the most common options are selling the property or properties or keeping them as investment properties, such as a rental.

In order to help you determine what to do, you need to do some planning. Each option will have its own tax ramifications as well as differences in your involvement moving forward. If you decide to hold onto and rent the property, you want to make sure you title the property according to your needs or the needs of you and your siblings. For instance, if you simply hold the property with another sibling on title as a joint owner with rights of survivorship and something happens to you, the property is likely to go entirely to your sibling should you predecease them, and vice versa. This in turn may disinherit your own family, so your spouse and kids.

So get with your attorney on how to structure the title first. An alternative may be that your portion of ownership goes into your own living trust, if you have one. You'll also want to be sure to do a cash flow analysis before making the decision to rent, meaning you'll want to have a good idea of the income it will generate, as well as the expenses that you may incur. So start by looking up current market rents for comparable homes in your area to get an idea of what you can charge, and then you'll want to estimate the expenses you will pay as a landlord.

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Some example expenses are things like insurance, property taxes, any repairs needed and repairs expected ongoing, property management costs, if you want to have someone take that role off your plate, any utilities you may decide to pay, and you'll want to allocate a fund that can help you keep the property functioning during times of vacancy. Almost like an emergency fund for your rental property. As far as the insurance goes, you'll want to understand what the current replacement cost of the home would be. The reason for this is that the replacement costs of the home has likely increased drastically over the years due to inflation, and your parents may not have adjusted their coverage for that when they owned the property.

This is important because in general, if at least 80% of the cost to replace the home is not insured, the insurance company will only partially cover you if a claim is made, so you may need to increase the coverage. Therefore, don't assume that you will pay the same amount in insurance premiums as your parents did. The same can be said for property taxes. As we discussed briefly in the last episode, you will want to understand how the property tax base will change. If the property taxes are to go up significantly, you need to account for that in your cash flow analysis of the property. That expense will be higher.

Again, don't assume you'll pay the same in taxes as your parents did. It would also be a good idea to consult your tax professional on how depreciation will affect your tax situation for the rental. Typically any depreciation benefit is a good thing because it's essentially a tax deduction. But there are rules as far as when you can start depreciating and how you go about it.

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That being said, there may also be other depreciation opportunities here, such as what is called a cost segregation study, which may allow you to depreciate different aspects of the property over different time periods and therefore may provide better benefits for your particular goals and situation. Your tax professional may be able to provide these cost segregation services themselves, or they may need to refer you to a specialist if they think that's the way to go.

And lastly, I want to caveat that you should not make decisions solely for tax purposes. In other words, don't let the tax tail wag the dog. While we all don't favor paying more than our fair share in taxes, they shouldn't be the primary driver of your decisions.

As an example, if you inherited property with other siblings, you'll want to be sure that everyone is on board with being a landlord or leaving the duties to just one of you. It is all too common for one of the beneficiaries to end up taking the lead as the landlord because they live closest to the property while the others sit back and just collect a check. Just be careful with this because it can lead to bigger family and financial issues down the road.

Now, other than deciding to hold on to a property to use as an investment property, your other main option is going to be to simply sell the property and you and or your other siblings can each go their own way and do whatever's best for their situation with the proceeds. This option is kind of like the easy button you used to see on commercials on TV.

However, there are also advantages and disadvantages. Just like anything else in life, it all comes down to your individual goals. So when deciding to sell a property that you've inherited, again, one of the main things is that you'll want to make sure everyone is on board if there are other new owners such as your siblings. And in many situations, the property will typically receive the step up in cost basis or tax basis to the market value of the property on the decedent's date of death. This is something we referred to last episode, meaning that you will likely have a taxable gain or loss when you sell it, depending on the change in the property's value from the date of death to the date of the sale.

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If sold fairly quickly after the decedent passes, there may not be much of a change at all and therefore potentially very little tax ramifications. Now, unfortunately with property, we don't have the benefit of being able to see what it's worth on any given day. It's not like the publicly traded stock markets where we can see the value of a certain company throughout the day. So in order to determine what the value of the property was as of the date of death, you need to get something called a date of death appraisal done by a qualified appraiser. You may consider actually getting more than one of these done so you can get an even better idea of its current market value.

Now, one additional item to keep in mind is that some of the closing costs, as well as any commissions that you may pay to a realtor, for example, for helping you sell the home, will generally increase your cost basis or tax basis in the home. Now, rather than getting too granular here, this in turn can possibly end up in a loss for tax purposes after the sale of the home. Again, make sure to check with your tax professional on this and how it will work in your situation.

But as a basic hypothetical example, let's say Dad passed away when the home was worth $1 million. You inherit it and take on a tax basis or cost basis of $1 million. You then sell it almost immediately for $1 million and you pay an estimated amount of about $65,000 in commissions and closing costs. This may increase your basis in that property to $1,065,000. And since you are selling it in this example for $1 million, you have a theoretical $65,000 capital loss. I mention this because if you do in fact incur a loss for tax purposes, this can present some tax planning opportunities to save you money somewhere else with your own assets. As an example, if you have investments in accounts other than retirement accounts, you can utilize this time to harvest gains in any appreciated assets you may have already owned yourself.

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I have talked about gain harvesting before in a previous episode, which I will link to in the show notes, if you hadn't heard that one. But generally you may be able to sell assets such as stocks, bonds or even other real estate that currently have a gain and part, if not all of the gains can be offset by that $65,000 capital loss in this example. Meaning you can mitigate or potentially eliminate taxes on those gains, at least at the federal level. Now, if you don't have any capital gains to offset with these losses, then each year you can typically use up to $3,000 of your bucket of losses, the 65,000 in this example, to offset all of your other income. You can keep using this each year until those losses run out, or you've offset some of them with any potential capital gains that you may incur in the future. As I mentioned before, this is just one way that the effects of an inheritance can actually blend with your personal situation and present other opportunities that often get overlooked.

If you decide to sell the property and receive the cash proceeds, it is obviously important to have a plan for that cash. How will you reinvest it? Should you pay off personal debts that you have? Do you leave it in a bank account? Do you need to live off of some of it for any period of time? And how do you go about doing that? These are some of the questions you should ask yourself that need to be assessed by drawing up a plan, first. As an example, if you sold a home and had $900,000 in cash in the bank, it's not going to be very smart to let it sit there idle so you can start spending random amounts from it. Otherwise, you'll likely find that in three years it's all gone.

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Now, I know you're saying to yourself, no way I would spend that much money so fast. But believe me, the more money that's staring you in the face, suddenly, the bigger your expenses will get. The same goes for any portion of an inheritance that comes from cash or other nonretirement accounts, such as bank accounts, transfer on death, investment accounts or trust accounts, whether they're invested or not, similar to the sale of an inherited property. In general, these types of accounts will also receive a full step up in tax or cost basis when inherited, if they were invested. Now, I want to caution you that when it comes to inheriting investments held in these accounts other than retirement accounts, you need to make sure that you stay on top of the company holding the investments when it comes to getting that step up in cost basis.

I have seen many times where this step is skipped or not done properly and adult children take on the investments and possibly sell some and then they incur large capital gains. Again, this is due to the tax or cost basis not being stepped up as of the date of death. Don't assume that these companies will do all of this for you automatically because they often won't. Get with your tax and financial advisor to determine what you'll need to do to get this done. On the flip side, if one or both of your parents are still alive and they have assets that are underwater, meaning they're worth less than what they bought them for, gifting some of those assets while they are alive may be more beneficial than leaving them to be inherited, since you will essentially have a step down in tax or cost basis if you inherit it instead.

This can result in a beneficiary such as yourself missing out on tax losses that can be used for your personal tax situation in the future. Now, always consult your tax professional, your attorney and or your financial advisor to see how this strategy may affect you. If Mom and Dad currently have assets that are worth considerably less than what they were originally purchased for, this strategy is different in that they need to be alive to accomplish. But if you're able to catch it sooner than later, it can save you and possibly the other beneficiaries a considerable amount of time and money, if done properly.

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Regardless of what asset or vehicle the liquid part of an inheritance comes from you'll need to give a purpose to it or multiple. Rather than immediately trying to spend it, let's say on a new vacation home or an RV, think about how it can be used to better your situation in the long run. For instance, you could allocate some of the cash or investments to pay off expensive credit card debt that you've accumulated. Then you can allocate some towards your own emergency fund, if you don't have one already. That way you don't have to get into credit card debt ever again, hopefully. You could reinvest part of the money for more longer term goals such as retirement income alongside your own retirement accounts. You can use it to fund long term care or long term care insurance. Maybe you fund Roth IRAs for you and your spouse or set aside some money to pay the taxes on potential Roth conversions of your own retirement accounts over the next several years.

The list goes on. In addition, you could allocate part of it to, say, live off in your early 60s along with some other income sources so that you can delay Social Security longer in order to get a higher benefit for life for you and your spouse. Now, this would be done by creating some sort of strategic withdrawal plan from the money and investments that you've inherited, but it can be a great strategy in and of itself. In other words, you don't want to just be randomly withdrawing money to live on. And by the way, the higher your Social Security benefit, the more your spouse will also receive for life should you predecease them.

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So this can also help with some of your estate planning. If you choose to live off some of the cash for a set number of years you may be able to keep your taxable income extremely low during that time as well. Maybe because instead of living on fully taxable withdrawals from a retirement account you begin to live off some of the sale proceeds or the cash which aren't taxable income. This, in turn, can possibly put you in a much lower tax bracket, leaving you more room to maybe convert some of your own pretax retirement accounts to tax free Roth IRAs. When in lower tax brackets, you are able to pay taxes on conversions now at a lower rate that you know versus later at a potentially much higher rate.

And to accomplish this, you can have some of the cash, inheritance or property proceeds set aside to actually pay those taxes owed from the conversions themselves. And as I mentioned briefly before, you may live off of a blend of some of the cash as well as some of your other resources in order to keep your income under certain tax thresholds. Some examples of these thresholds are the point in which your Social Security becomes taxable or the point in which you start to pay Medicare premium surcharges. So this is also known as IRMA surcharges. Or you might want to stay under the threshold in order to receive a portion or all of the premium tax credit, which is basically a subsidy towards your health insurance premiums if you're getting health insurance from the health insurance marketplace.

Now, staying under these can possibly save you thousands of dollars a year in additional taxes from sources that you may not have even realized were taxing you. Now, I want to revisit Roth IRAs, since they can be one of the lowest hanging fruit as far as strategies go, which is the potential to fund a Roth IRA for you and potentially your spouse as well. If your income is under certain thresholds each year and at least one of you has adequate earned income from a job or a business, you can generally fund a Roth IRA up to an annual maximum. Currently, in 2023, that number is $6,500 per year if you are under age 50, and $7,500 a year if you're over age 50.

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As long as you have enough earned income, you can fund one of these for yourself as well as a spouse. So why is this beneficial? Well, if you remember from previous episodes, Roth IRAs are one of the only investment vehicles in the world that can provide compounding tax free growth, provided you meet some relatively basic rules. And I'll include a link to a blog article that discusses those rules in the show notes for today's episode. So, let's say you inherit money outside of a retirement account, or you have proceeds from the sale of a home that you decide to, let's say, put in a CD at the bank or invest in stocks, for example.

You will pay taxes each year on the interest or the dividends that you earn on those investments. But imagine you are eligible to fully fund two Roth IRAs each year, one for you and one for your spouse. So you fund them with that money you inherited and invest in the exact same things you were going to invest in anyway. You are now earning that interest and dividends in an account that is compounding tax free. You might do this over many years and be able to accumulate large amounts in these Roth accounts.

And again, you'll be shifting investments from an account that is taxable every year to an account that can earn that same interest or dividends tax free. This is one of the easiest and best strategies, in my opinion, for building wealth. Plus, it's very tax efficient. I'll put it to you this way. One day, you will need to spend large, lump sums of money in retirement, whether it's for something fun like an RV or something not so fun, like replacing your roof. And by the way, this almost inevitably happens at the exact worst times.

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Wouldn't it be nice to have access to money in an account that you can spend from that won't blow up your tax situation because it won't be taxable? Yeah, I would think so. Another great benefit of Roth accounts is for estate planning purposes. If you, let's say, predecease your spouse, their tax situation will likely become much worse due to having to file single in the years following your passing. If there are Roth accounts left to your spouse, they can typically use that money without incurring that extra taxation, because again, the withdrawals, if a couple simple rules are met, will not be taxable.

Again, these are just more ways that we can use inheritances to blend with your personal situation and continue to accumulate wealth for you and your family. Now, while we're on the topic of retirement accounts, I want to go over some things to consider when inheriting those pretax retirement accounts that we talked about last episode, such as 401(k)s and traditional IRAs from a parent, for example. The first important thing to note is whether or not your parents were taking their own, what are called required minimum distributions, or RMDs, before they passed.

This refers to a minimum amount that the IRS requires you to take out of these accounts and pay taxes on each year. If they were already taking these each year but had not yet taken that RMD in the year they passed, you as the beneficiary or you and your siblings as beneficiaries will generally need to take it on their behalf before year end, and each of you will pay your respective taxes due on that money.

If this is the case, you'll want to know what that required amount is and have a purpose for it, once it's taken. You can use this money for any one of your personal financial goals, like we discussed earlier, but just know that it will affect your own personal tax situation in the year you take it. If you don't take it, you will pay taxes and penalties on the amount not taken that was supposed to be taken. In addition to that, as we discussed in the last episode, which I will refer to in the show notes for today's episode, you will now have your own RMDs to take as a beneficiary, and typically within ten years. Therefore, you'll want a strategy as to how you are going to repurpose that money as you take it.

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You might consider allocating those distributions to other goals that you may have, such as funding your own long term care. Why would this be beneficial? Because something like a long term care event in your future could substantially eat into any wealth you've accumulated on your own or inherited. You may decide to fund your own possible long term care by reinvesting that money. Or maybe you look into using the distributions to pay for premiums for some amount of long term care insurance.

This is something you'll want to start planning for yourself or with your financial advisor. I cannot stress enough the importance of long term care planning. More often than not, you have had to take on the responsibility of caring for your own parent at this stage and you understand how much of a financial and emotional undertaking it truly is. Do you want your own spouse and or children to go through the same process. When inheriting one of these retirement accounts, you'll also want to consider the fact that when taking these distributions or RMDs, would it be beneficial to delay or reduce the amounts you withdraw from your own retirement accounts until the inherited account is depleted?

This is where doing some cash flow planning or budgeting can be very beneficial. In addition, the required minimum distributions or RMDs from an inherited retirement account are just minimums. You can take more if needed, or you find it more beneficial tax wise. For example, if even after taking the minimums you still find yourself in, say, the 12% tax bracket, could you take more in a given year or over multiple years to fill up that tax bracket and pay 12% on the money versus taking more later and potentially paying more than 12% later? Maybe after you started taking Social Security or something like that?

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Should you begin to take more after you retire and your income is a little bit lower than when it was when you were working? This is yet another important tax consideration to consider reviewing with your professional advisors, that could save you thousands in the long run. And quickly, one important side note I want to mention, is that you cannot convert an inherited IRA to a Roth IRA. If you are going to explore converting money to a tax free Roth account, you will need to convert your own pre tax retirement money.

Whatever extra income or additional assets that you may now have as part of your personal finances, after an inheritance, you'll want to have a plan for it. Don't let it all disappear down a spending black hole. This is by far the most common way financial windfalls disappear faster than expected. Far too often there is no plan for anything whatsoever and you find yourself with bigger spending habits and bills simply because more money is there.

Don't be a victim of this. If accumulating wealth for you and your family to live a more comfortable life and fulfilling life is important to you and you are looking for peace in your financial life versus constant headaches, take charge of your situation and be mindful of the financial decisions you make. If your parents were successful in accumulating generational wealth, pay it forward by trying your best to make the best possible decisions for your own family.

That does it for today's episode. Hopefully, you were able to find a nugget or two that can help you with your own situation. 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.

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You can go to the Ask a Question page at the top. I will also include a link in the show notes and ask a question. I will do my best to answer it in a future episode. If you have a minute and find this information actionable and insightful, and you want to stay up to date on the latest and useful retirement planning content, please subscribe to our 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 links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/29.

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 current markets in layman's terms. We always strive to include something actionable in our newsletters so that you can implement strategies right away, such as how-to guides and other simplified strategies. Again, this can all be found at retiredishpodcast.com/29. Thanks again for tuning in and following along. See you next time on Retired-ish.

00:27:23 [DISCLAIMER]
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.