Question: My father recently passed away and he left a significant inheritance to me and my siblings. My father had a successful career and was always very careful with his money. Now I will be receiving over one million dollars from his estate. This is more money than my wife and I have ever dealt with, and we want to make sure we use it wisely. How do we make sure we don’t waste it?
Questions like the one above are becoming more common and will increase in the years ahead as the greatest wealth transfer in history accelerates. Cerulli and Associates projects that in the next two decades, total wealth transfers will approximate $84 Trillion dollars as the silent generation and baby boomers transition their wealth to their children.
There are many challenges that accompany a sudden inheritance. First, it often comes at an emotionally difficult time. When a close family member passes away, money and finances are often the last things anyone wants to think about. The inheritance can also cause the heir to feel guilty as if they are benefiting from the death of someone they cared about.
While these emotional challenges can be difficult, there is an additional challenge that comes with an inheritance; it is sudden. Often the individual receiving the money has never dealt with a similar amount of money prior to receiving the inheritance. Rather than building wealth gradually and developing the skills to manage it over the years, they are immediately handed the inherited assets along with the related challenges and must learn to navigate them quickly.
While everyone’s situation is unique, there are some general rules that are wise to consider in most circumstances.
The following graphic helps lay out a simple three step framework for dealing with the sudden wealth that can accompany an inheritance.
Key Takeaway:
The sudden nature of inherited wealth combined with the associated emotional challenges of losing a loved one can create significant complexity for individuals.
Initial Understanding:
When an individual first inherits a large sum of money, the first important step is to recognize that emotionally challenging times usually aren’t the best times to make major decisions. For individuals who are inheriting funds from a loved one and are still grieving, often it is best to delay making any major financial decisions for a few months.
While major decisions can be delayed, it is important to consider the assets that are being inherited and develop an initial understanding of the types of assets and accounts included. Depending on the assets and account types, there may be some small immediate steps that must be taken.
For example, if balances are in retirement accounts, there may be required minimum distributions that need to be taken before the end of the year. If there is cash, it may be important to ensure it is in a high-yield savings account or money market account earning reasonable interest.
However, aside from the initial review of the assets, major decisions can often be delayed until there is time to take a step back and consider the new reality of your financial situation objectively.
When ready, the individual can begin this review by considering the administrative steps necessary as a result of their new situation.
Key Takeaway:
It is often wise to delay making major financial decisions after the sudden loss of a loved one. While small steps may need to be taken immediately, major decisions can typically be delayed.
Administrative Review:
To start the administrative review, it is important to take an inventory and understand what types of assets were received, and whether any of the funds were in retirement accounts.
Many of the original owner’s accounts may need to be transferred or retitled. If retirement accounts such as Traditional IRAs, Roth IRAs, 401(k)s, etc. are included in the inheritance, the individual who inherited the funds will be required to withdraw the funds over a specified time period to satisfy required minimum distribution rules.
Required minimum distributions for beneficiaries vary depending on multiple factors such as when the original account owner passed away, whether the beneficiaries qualify for a special status called an “eligible designated beneficiary,” and the type of account being received. However, in most cases, the account will have to be distributed within 10 years.
It is also important to understand the account types inherited in order to plan for the tax consequences of accessing the funds in the future. For example, if an individual inherits a pre-tax retirement account, the funds will be taxable to the beneficiary when they are taken out of the account.
On the other hand, if the inheritance is strictly cash in a bank account, the beneficiary will have full access to any funds received without having any personal tax consequences.
Other assets that are often inherited are land, real estate, and investments. If these assets were owned personally by the deceased individual (i.e. not in a retirement account), they will generally receive a stepped-up tax basis. This means that the beneficiary’s tax basis in the asset will be equal to the fair market value of the asset on the date their loved one passed away.
Before we discuss an example, let’s explain tax basis. Tax basis is the number that determines the level of investment into an asset. The Internal Revenue Code allows taxpayers to recover their investment in an asset tax-free. Accordingly, the taxable gain or loss on the sale of an asset is the proceeds received minus their tax basis in that asset.
To demonstrate, let’s say a parent purchased ABC Company stock many years ago for a total value of $20,000, and it is held in a standard taxable brokerage account (i.e. not an IRA or 401k). Now many years later those shares are worth $100,000 which means there would be a taxable capital gain of $80,000 if the stock was sold while the parent was still alive.
However, if the parent passes away and the beneficiary receives the ABC Company stock, current tax law states that the beneficiary’s tax basis will be stepped-up to the fair market value of the stock on the date their parent passed away (i.e. $100,000). This will allow the beneficiary to sell the stock and pay minimal taxes. The following chart demonstrates this concept:
In addition to reviewing the assets received and understanding the tax implications of accessing the funds, receiving a large inheritance can create new problems that must be addressed. For example, a large inheritance may require an updated estate plan.
Those who previously did not have significant assets, may now need to consider what will happen when they pass away. If they have children, do they need to dictate how and when they will have access to their future inheritance?
Additionally, individuals whose net worth is higher become more attractive targets for lawsuits and scammers. Often, it makes sense to review insurance coverages to ensure appropriate protection is in place and consider taking steps to reduce the chances that assets are misappropriated or stolen through identity theft.
By performing an administrative review after receiving an inheritance, an individual can ensure they understand what they’ve received, what steps need to be taken to comply with the required minimum distribution and tax rules, and what updates they should consider to their own financial plan to ensure their assets are adequately protected and will be passed on as they wish.
Personal Goal Review:
Once the administrative review is complete, the next step is to review whether personal goals have changed. For many individuals, receiving a substantial inheritance may give them additional flexibility in the lifestyle they are able to live and the things they are able to afford.
When considering these opportunities, it is important to think about them in light of the overall financial plan. After receiving a large sum, it often feels like the sky is the limit and many individuals immediately start looking at ways to spend the money. It is easy to splurge on lifelong dreams such as renovating the house, buying a vacation property, purchasing new vehicles, or luxury travel.
While some of these purchases may make sense, they should be viewed in the context of how they fit into the overall financial plan to ensure that the spending does not encroach on more important, but often less exciting, goals that may be present (i.e. retirement, children’s college, etc.).
Key Takeaway:
Completing an administrative review as well as a personal goal review will help set you up for long-term financial success.
Surround Yourself with a Quality Team:
Many individuals will find that the objective review of their new situation requires assistance from a quality team of professionals. Often that includes working with a certified public accountant, estate attorney, and financial advisor.
It can also include other professionals such as a real estate agent if real estate is involved or an insurance agent if insurance coverages need to be reviewed.
Working with a quality team not only provides the skillset to appropriately conduct the objective review but also provides access to independent third parties who can provide wise counsel that is less likely to be impacted by the emotional strain of losing a loved one.
When building your quality team, it is important to properly evaluate each professional. When it comes to a financial advisor, we recommend finding an advisor who is a fiduciary 100% of the time, fee-only (i.e. no commission-based compensation), and independent.
It is also important that your financial advisor helps coordinate a comprehensive approach to your financial situation by working closely with the other members of your team (CPA, estate attorney, etc.) to ensure that everyone is providing coordinated advice based on your unique goals and objectives.
Key Takeaway:
Choose a quality team that can provide objective and independent counsel. When hiring a financial advisor, we recommend an advisor who is fiduciary at all times, fee only, and independent.
Implementing the Plan:
Once a quality team is in place and the objective review is complete, the updated plan can be created and implemented. Typically, this includes determining how much of the inheritance should be used to pay down debt and establish an emergency fund, how much should be set aside and invested for the future, and what portion can be used to increase lifestyle or check off those bucket list purchases.
In most cases, the analysis should start by reviewing the best way to ensure your personal finances are in order. This means considering whether you have high-interest rate debt such as credit cards, personal lines of credit, car loans, student loans, etc. Often it makes sense to eliminate these balances.
It also is important to ensure an appropriate emergency fund is in place. Generally, keeping 3-6 months of cash readily available in a high-yield savings account is sufficient, but each individual should consider their own facts and circumstances.
Once your current financial situation is in good order, it is important to review how the inheritance can contribute toward achieving future financial goals such as retirement, children’s college expenses, or charitable giving.
When preparing for these future goals, it is important to determine how the funds will be invested, what strategies can minimize the tax burden of accessing the funds in the future, and how the estate plan should be structured to ensure the assets are passed on efficiently.
Once these future goals are established and the plan is in place to accomplish them, any remaining funds can be used for more exciting and enjoyable purchases without concern that the purchases will impair the ability to achieve the most important future goals.
Key Takeaway:
We recommend taking a thoughtful approach that utilizes the inherited funds in a way that is consistent with the individual’s personal financial plan.
Conclusion:
As the Great Wealth Transfer continues over the next twenty years, more and more individuals and families will be faced with the blessings and challenges that come from a significant inheritance.
While receiving a financial windfall is a problem most individuals would like to have, there are many hard decisions and added complexities that comes from an inheritance – especially given the emotions and grief that often accompanies the death that brought about the inheritance in the first place.
For individuals who are new to the complexities that come with managing a large inheritance, assembling a quality team to walk you through the process and ensure the appropriate steps are taken at the appropriate times can be the difference between an inheritance that is a blessing versus an added hardship.
At Prairiewood, we are focused on helping our clients manage their wealth wisely. Our comprehensive approach of serving as a client’s Family CFO allows us to ensure their entire financial life is coordinated.
For individuals who already have quality team members in place such as a certified public accountant and estate attorney, we are happy to coordinate directly with their established team. For other individuals who want to assemble a quality team and don’t know where to start, we can help facilitate that process by connecting you with professionals we know and trust from our professional network.
If you are interested in meeting with one of our Family CFOs to create a plan for a recent inheritance or simply to ensure your family’s finances are being optimized to meet your future goals, we would love to connect to see if what we do is right for you.
