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You Just Received Notice of an Inheritance: What Should You Do?

You’ve just been notified that you are receiving an inheritance. Someone cared enough about you to include you in his or her estate. Maybe it was a parent, an aunt or uncle, a sibling, or a longtime friend. Maybe you were expecting it. Then again, maybe the notice came as a complete surprise. Regardless of the circumstances, you’ve just been notified that you are receiving an inheritance. What should you do?

It’s Complicated

Receiving an inheritance may be more complicated than it first appears. You may be thinking, “How complicated can it be to receive a financial windfall from someone who cared about me?” Yesterday you didn’t have an inheritance, and today you’ve been notified that you do. What’s so complicated about that?

Whether you had been expecting it or not, new found wealth may come with many strings attached. In order to avoid irrevocable mistakes that could lead to unnecessary taxation, or forfeiture of specific privileges afforded to folks receiving an inheritance you have to know the rules. Or, work with someone who does that can guide you through the process to ensure that you use the letter of the law to your full advantage. It is important to understand what your rights are and how to take appropriate actions in order to receive your inheritance efficiently.

An Inheritance May Come in Many Forms

Your inheritance may come in many different forms. Each situation may come with its own set of rules and privileges regarding how you may receive your inheritance. Your potential tax liability associated with each inheritance situation may vary quite dramatically from one to another. There are plenty of opportunities to error along the way.

You may be the beneficiary of a retirement account. Retirement accounts are not all created equal. Some may be fully taxable to you, while others may completely tax-free.

For example, you may be listed as a beneficiary of a pre-tax accounts such as an IRA, 401(k), or another IOU to the IRS. There are specific rules governing what you can and cannot do with an inheritance from a traditional IRA. On the other hand, there are different rules governing what you can and cannot do with an inheritance from a qualified retirement plan like a 401K. Both types of accounts a pre-tax, meaning you will eventually have to pay taxes on the distributions. However, the choices you may and the actions you take will determine the tax efficiency of your inheritance.

Perhaps you are the recipient of a never-taxed account like a Roth IRA, or Roth 401K. These are two examples of tax-free accounts. On the surface, this seems pretty straight forward. You don’t have to worry about paying any tax on the distributions. What’s so complicated? The choices you make about how to receive these dollars may have a significant impact with regards to the total tax benefits you are entitled under the law. Whether you forfeit these benefits or not will be a direct result of the decisions you make. Act accordingly.

You may also inherit after-tax assets. For example, you might be listed as the beneficiary of cash in a savings or checking account held in a bank or credit union. Maybe someone leaves you investment’s such as stocks, bonds, or mutual funds in an individual brokerage account. Perhaps you inherit real estate such as your childhood home, or vacation property previously owned by your parents. You may also be the named beneficiary of life insurance contract proceeds form a life insurance or annuity policy. The process for taking ownership of each of these asset types may be different. Each asset example given has its own considerations as to how and when you might take ownership. There may also be unexpected tax liabilities that you need to be aware of with a few of them.

These are just a few examples of what some folks may inherit from a benefactor like a parent or a close living relative. Each one of these assets comes with its own set of rules to understand when you take ownership. If you don’t know the rules you may end up paying unnecessary taxes, or miss out on specific privileges afforded to you as a beneficiary.

Inheriting Pre-Tax Money (i.e. IRA or 401K):

When you inherit a pre-tax account you also inherit the previous owners deferred tax liability. Pre-tax accounts like IRAs and 401(k)s allow the owner to defer taxes. If your mother made contributions to a traditional IRA or 401K in preparation for retirement she most likely received a tax deduction on the contributions. She was also allowed to defer taxes on the interest or investment gains earned.

However, those taxes have to be paid as some point by someone. During her lifetime she would have paid taxes on the distributions at her tax rate. However, once she passes and leaves the remaining account to you, the tax liability doesn’t vanish. On the contrary, you inherit both the account assets, and the tax liability. Distributions are now taxable to you, and at your tax rate as the beneficiary.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act was passed in December 2019. Many of the rules effecting the inheritance of pre-tax accounts took effect beginning in January of 2020. With regard to inheriting pre-tax accounts it created two classes of Designated Beneficiaries (DB), and new rules affecting what each class is permitted to do.

Most notably it created a new “10-Year” distribution rule for inherited pre-tax accounts. Under the new rule, all funds within the inherited pre-tax account must be distributed, and subsequently taxed, by the end of the 10th year. The 10-year clock begins the year following the date of death.

The two classes of Designated Beneficiaries are broken into those who are “eligible” to stretch the inherited account distributions over the lifetime of the beneficiary, and those who are “not eligible” to do so. Eligible Designated Beneficiaries (EDB) don’t have to follow the new 10-year rule, and all other Designated Beneficiaries do have to follow the new rule.

Understanding the category of beneficiary that you fall under is imperative to making a good decision about what to do with your inherited pre-tax accounts.

Are You an Eligible Designated Beneficiary?

As previously mentioned Eligible Designated Beneficiaries (EDB) are eligible to “stretch” the inherited pre-tax account over their own life expectancy. This means that a beneficiary can maintain the account in tax deferment, and continue to potentially grow the assets in the account. They are only required to take minimum distributions annually. However, they are not limited to the amount that they could elect to distribute. The ability to stretch distributions is now a privilege limited to a few, not a requirement.  A poor decision made on behalf of the eligible beneficiary could forfeit this special privilege. 

Prior to the SECAURE Act, most beneficiaries would have been considered Eligible Designated beneficiaries. Virtually anyone (natural person) who inherited an IRA prior to the SECURE Act had the opportunity to stretch the account of the decedent in order to defer their tax liability. (Note: Anyone who took advantage of this privilege in the past is still permitted to continue stretching the previously inherited IRA so long as it was inherited prior to January 1st of 2020.)

However, after the SECURE Act went into effect the list of EDBs was shortened significantly. Not just anyone can stretch an IRA anymore. The list of EDB is quite short. Here are five different types of eligible designated beneficiaries that may stretch an inherited pre-tax account:

  1. The Surviving Spouse
    1. The surviving spouse can claim either the IRA as her own, or receive the IRA as a spousal stretch IRA. Knowing which way to receive this inheritance is more advantageous and it depends on many factors. Don’t make this decision without understanding all of the rules first!
  2. Disabled persons
    1. A person who is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which is expected to result in death or to be of long-continued and indefinite duration
  3. Chronically ill persons
    1. A person who is unable to perform 2 of the 6 activities of daily living without the substantive assistance of another person for an indefinite duration
  4. A beneficiary no more than 10 years younger than the decedent
    1. This could be anyone! For example, a sibling of the decedent whose age is within 10 years, or a best friend from high school or college. It really doesn’t matter as long as the difference between the beneficiary’s age and the decedent’s age is 10 years or less.
  5. The decedent’s minor child (does not generally include step-children)
    1. The decedents minor child may stretch the inherited account until age of majority, or up until the time that the child is no longer pursuing an active course of education but not beyond age 26. After reaching age of majority, or no longer pursing education, or after reaching age 26 – the child’s “10-year” rule period to distribute the remaining pre-tax account balance begins.

All other Designated Beneficiaries who are natural persons (a trust named as a beneficiary would not be a natural person) are not eligible to stretch the IRA over their life expectancy, and therefore must abide by the new “10-year Rule.”

The good news is that the 10-year rule does not mandate any required minimum distribution to be taken. The bad news is that all account assets must be distributed from the pre-tax account by the end of the 10th year following the death of decedent. Essentially, the government in its action is forcing the taxation of the account at a much faster pace than what is required by and Eligible Designated Beneficiaries.

 A Designation Beneficiary can distribute as much or as little of the inherited account assets as they choose from the time the account is inherited to the end of the 10th year. Taking smaller distributions each year might help to spread the tax liability over time thus help reduce the total taxes paid. There may even be a way to spread the taxes over a total of 11 years. How?

The first year of the 10-year rules begins the year following the year of death of the decedent. If your father passes in February 2021 the first year of your ten-year period begins January 1 of 2022. What’s to stop you from taking a distribution during the year of death, and thus having 11 years to distribute the tax liability? Nothing!

However, distributions from pre-tax accounts may have a negative impact on your personal finances. They may increase your effective tax rate, impact your college bound child’s ability to qualify for student aid, increase your adjusted gross income (AGI) impacting Medicare premiums, drive up provisional income which determines the percentage of your social security benefits that are subject to tax, and so on. When you distribute pre-tax accounts assets, it can complicate things!

What about Roth IRAs? If you inherit a Roth IRA as a Designated Beneficiary you are still subjected to the 10-year rule. You may be thinking, “So what? The distributions are free from tax! Who cares?” Once the assets are distributed they become after-tax dollars. If you invest after tax dollars you are liable to pay taxes on the interest, long-term or short-term capital gains, and dividends. Imagine if you inherit a Roth IRA worth $200,000. You elect to keep it in deferent rather than distribute it. Invested in the market at 7% the inherited Roth IRA grows to approximately $400,000 over 10 years. It’s all tax free!

On the contrary. If you would have distributed the $200,000 Roth IRA immediately after inheriting the assets it would have been a nontaxable event. However, this would have become an after-tax account at that point. If you invested in the market at 7% it would have grown to $400,000 also. However, assuming you held each investment purchased for more than 12 months you would have had to pay long-term capital gains taxes on the $200,000 of growth. That would be a missed opportunity, would you agree?

Inheriting After-Tax Assets

Inheriting after tax assets are quite different than inheriting pre-tax retirement accounts. Some assets may have named beneficiaries, and others may not. Assets with unnamed beneficiaries, for example real estate property or after-tax accounts without a transfer-on-death (TOD) beneficiary designation will likely be subjected to the estate settling process and may have to be probated before distribution can be made. On the other hand, assets with named beneficiaries such as bank accounts or brokerage accounts with a transfer-on-death designated beneficiary may bypass the estate settling process. 

It is important to note that after tax assets such as real estate, stocks, bonds, mutual funds and other types of property receive special tax treatment upon the passing of the owner.  The basis of the asset, or the amount paid for it, is “stepped up or down” to the market value as of the date of the decedent death. 

Effectively, all appreciated capital under the deceased owner would be inherited at the market value as of the date of death, wiping clean any responsibility of the beneficiaries to pay capital gains taxes on the appreciated value.

For example, if your parent owned a lake home and originally paid $100,000 for it 25 years ago before the lake was popular, and today the property is worth $800,000 there would be a capital gain of $700,000 if they sold it. However, if your parents did not sell it, but rather passed it on to you at death, your new stepped up basis is $800,000. You would avoid paying capital gains tax on the difference between what they had paid for the property, and what the current market value of the property is at the time of your parent’s death.  In this example, that’s $700,000 of capital gains tax avoided. If they were to give this property to you in whole or partially by placing your name on the deed while they were alive you would not get the step up in basis at their death. Their basis, $100,000, would become your basis. Their capital gain of $700,00 would become your capital gain if you sold the property. That would be a big mistake!

The same thing applies to appreciated securities such as stocks and bonds. Imagine your parents bought 100 shares of company XYZ at $100 a share 20 years ago. The initial investment was $10,000. Now imagine they held on to them, and those shares are now worth $40,000.  There would be a capital gain of $30,000 if they were to sell their shares.

Now imagine if they hold those shares until the day they pass. A few more years go by and then they leave them to you in a brokerage account. At the time of their passing the market value of each share is worth $600, or $60,000 total. You would receive those inherited shares from your deceased parent with a stepped-up basis of $600 per share. The market value as of the date of death becomes your new basis. You escape having to pay capital gains tax on $50,000 of appreciated value. However, financial institutions make mistakes! You’ll want to verify that they have updated the cost basis correctly so that you don’t pay unnecessary taxes. 

You’ve Just Been Notified! What Should You Do?

What should you do when you’ve been notified that you’re receiving an inheritance?

  • Gather the necessary documents.
    • Obtain multiple copies of death certificate – each financial institution may require an original copy when processing your beneficiary claims form
    • Gather beneficiary claim forms for each financial institution in which you’ve been named on an account as a beneficiary.
    • Collect financial statements from each financial institution involved
    • Gather copies of the estate documents if possible
    • If you are named as trustee or executor of the estate you will have to obtain authorization to transact on behalf of the trust or estate.
  • Carefully evaluate how to receive the proceeds from the various assets and account types.
    • Determine how will you receive cash distributions?
    • Should you receive property such as stock in-kind, or sell the property for cash first?
    • Are you an Eligible Designated Beneficiary of a pre-tax account, or are you a designated beneficiary subject to the 10-year rule?
    • Is the asset a pretax account like an IRA, or never-taxed account like a Roth IRA?
    • How do these factors affect your decision on how to receive the inheritance?

When you receive an inheritance from a relative or a friend who has passed emotions may be running high. Those emotions may cloud your judgment, and make it difficult for you to make critical decisions. To avoid making mistakes get organized and ask for help.

It is advised to SLOW DOWN, take a deep breath, and take your time.  Remember, decisions made in haste will often lead to waste.

Get yourself organized, and work with a financial professional who has been down this road before. Choose one who can guide you through all of the steps you’ll need to take and the decisions you will need to make before taking an irrevocable action.

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