What to Do With an Inheritance
You may have heard the expression ‘The Great Wealth Transfer’ over the past couple years. If you have not, this is in reference to the current transition from the Baby Boomer generation to GenX and Millennials. It is estimated that the Baby Boomer generation has over $68 trillion in assets that will be passed on to children and grandchildren over the next 10-20 years.
While an incredible blessing to be able to receive an inheritance, this can create additional challenges and stresses to surviving family members. According to a recent study by New York Life, only 42% of adults expecting an inheritance feel comfortable handling the new wealth. This can range from discomfort of handling the actual finances, to discomfort with the psychology of new money they were unprepared for.
Slow Down
The first thing anyone going through this needs to do is slow down. Before even thinking about money or finances, take the time to grieve. This is a massive life change and you need to be able to approach these next decisions with a clear mind. Depending on the assets received, it can sometimes take up to 9 months to fully receive money, especially if a probate court is involved. After getting through the bureaucracy of transferring the assets, make a concerted effort to do nothing at first. This part sounds a lot easier than it is in practice.
Working with a team of trusted individuals can help you formulate a plan that is not only financially prudent but also something that you will feel comfortable sticking with for the long term. The beauty of a quality financial plan should be the simplicity. At Westview, we view a financial plan as a living document that always starts with the same beginning hierarchy of saving;
Pay high interest debts
Establish an emergency fund
Fund retirement plans
401k match
IRA’s
Max 401k
Fund taxable investments
Plan for your legacy
Understand Tax Impacts
With the very high level of federal estate tax exemption currently, the majority of Americans do not need to worry about a large estate tax bill. However, some states do have estate and/or inheritance taxes. As a Vermont based firm, we do have a state estate tax with a much lower exemption (currently $5 million) while there are 5 other states that have a tax on the inheritance (Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania). Another reason to stress the importance of working with a trusted team to navigate these differences.
Of the money you do inherit, there are some other tax considerations that our team helps clients navigate: step-up in cost basis and the new rules regarding inherited retirement assets (i.e. inherited IRA 10 year rule established in 2020).
Step up in basis sounds complex but is actually quite straightforward. Any assets the deceased owns simply gets a new cost basis at their date of death. For example; if your parents bought their house for $250,000 in 1995 and passed away in 2023 when the house was worth $500,000, when you decide to sell the home, you are only liable for any gain above $500,000. This applies to other assets as well like stocks and bonds. The benefit to the inheritor is that they can reinvest the portfolio or dispose of property with minimal or zero tax impact.
The 10 year retirement account rules went into effect for any person who passed away on or after January 1st, 2020 via the SECURE Act. This change drastically changed how non-spouses can receive inherited IRA/401k/403b/etc. Prior to this change, there was a complex lifetime table that set the rate at which you were required to take distributions (and pay the taxes) from the account. Now, it is straightforward but a shortened time frame of 10 years to withdraw the account. You can break that up however you want within that 10 year period or all at once. While less complex, it can be a drastic tax burden, especially higher earners late in their careers. For example, ff you were to inherit a $1,000,000 IRA from your parent, you would likely be adding $100k plus to your taxable income every year for a decade. This is taxed as ordinary income and you can see how it quickly can add up!
Pay Debts
After receiving an inheritance, the most important step is to pay down ‘bad debts’ and get back to zero. Bad debts are generally higher interest and include credit cards, student loans, car loans, and personal loans. As a general rule, assume any debt above average inflation rates or not tied to an appreciating asset to be ‘high interest’.
Establish an Emergency Fund
While establishing an emergency fund may sound basic, it is often overlooked. The main reason people intentionally leave an inheritance to their heirs is to provide financial security. This is the easiest and quickest way to do so.
Fund Retirement Savings and Investments
Once the first two buckets (paying off debt and funding an emergency fund) have been satisfied, the additional inheritance opens up options to supercharge your retirement savings. If left with a cash balance, you could be able to divert some of your income to retirement savings and potentially max-out tax advantaged accounts such as 401(k)’s and IRA’s.
After maxing out retirement savings you can begin to fund taxable accounts (such as individual or joint investment accounts) and/or maybe you wish to start (or increase) funding a child’s 529 plan. Either way, taking a disciplined approach to how this money is invested will have lasting effects for your life and future generations.
As with any investment plan, the key is to focus on the long term and not over complicate. At Westview, we take great pride in building customized portfolios for our clients that match their personal financial goals, objectives, and risk tolerance to meet said goals. Whether you are an existing client who received an inheritance or a new client, we take a similar approach to planning and investing for your future.
Make the Most of This Change
Many people feel immense pressure and sometimes guilt at the responsibility of handling their parents' wealth after their passing. It is always important to understand why we save and invest. There is not a one size fits all answer to something this complex so it is always important to discuss and plan with a trusted team. As a seasoned team and fiduciary, Westview can provide a level of attention and detail to your financial future.