You have just received an inheritance. What do you do now? You could spend it on some extravagance, but you would be better off doing two things first: assessing the tax ramifications and thinking about some investment options.
"Death taxes" are somewhat misunderstood, as people can find the two types of death taxes confusing. Estate taxes apply to the front end of the wealth transfer process, and are subtracted from the overall value of the estate. They reduce the size of your inheritance upfront, but you have no further tax obligation. Inheritance taxes, where they exist, apply to recipients. There are no federal inheritance taxes, and only six states impose inheritance taxes.
State inheritance taxes depend on income as well as the inheritor's relationship to the deceased. Taxes are applied on a sliding scale from one to twenty percent. Even though it applies to the recipient of the inheritance, the tax is applied based on where the deceased lived — so you must check the state laws there to see if you owe any state inheritance taxes.
Income tax does not apply to inherited cash or assets, but non-cash assets will be subject to tax whenever they are sold. The basis of the sold asset is stepped up to the value at the time of death — in other words, if you inherit your parent's house and sell it one year later, the capital gain or loss that affects your taxes is based on that one-year change in value. Otherwise, you would be forced to pay capital gains on the change in value between the sale date and when your parents bought the house, adding thousands to your tax bill.
The rules are slightly different among the different non-cash assets. For savings bonds, the only taxes you will owe are on the interest accrued during the decedent's life (assuming that interest reporting was deferred until redemption). Inherited annuities accrue taxes at the ordinary tax rate, but the exact amount and timing of payment depends on the type of annuity (employer-based or private), the annuity terms, and whether distributions have started. The issuer of the annuity will have the relevant details.
The strategy for inherited retirement accounts (401(k)s and IRAs) depends on your relationship with the deceased and your respective ages.
- You and Deceased Spouse Are over 70-1/2 – Minimum distributions have already started. You can leave things as is and receive the distributions, roll it into an inherited IRA or roll it into your own spousal IRA — usually the least painful choice for the next generation after you pass away.
- You Are a Spouse Age 59-1/2 to 70-1/2 – The same options apply, but the spousal option is better still, since you can delay distributions until 70-1/2.
- You Are a Spouse under Age 59-1/2 – In this case, the situation is reversed. Early distributions are subject to a 10% penalty under the spousal IRA, but not under the other options.
- You Are a Non-Spouse – If the deceased was older than 70-1/2, you can either take required minimum distributions that are based on the theoretical life expectancy of the deceased or roll the inheritance over into an inherited IRA and draw based on your own life expectancy. When the deceased is younger than 70-1/2, you have the added option of withdrawing all of the money within five years (although that generally produces painful tax bills).
Once the inheritance and tax issues are dealt with, you can move on to what to do with your inherited windfall. Cash inheritances are best used to address any high-interest bills (credit cards are an example) or to pay down mortgage debt by making extra payments against principal. Consider creating an emergency fund as well.
If you have not maxed out your IRA or 401(k) contributions, now is the time. Any leftover funds should be placed in liquid investments like money markets or laddered CDs to give you time to lay out an investment plan unless you have other specific investment needs, like a 529 college plan for your kids.
Inherited assets like stocks or real estate should be integrated into your portfolio, and should then be rebalanced to return to your risk profile. That may require selling some of the stock you already own or the stock you inherited to manage your risk.
With prudent planning, you can make the most out of your inheritance. Resist the urge to splurge and you will be thankful later.