An increasing number of boomer-aged families are receiving inheritances; it's all part of a trillion-dollar transfer of wealth that will happen over the next several decades. Gen. Xers are next in line.
Many families near or in retirement have aging parents, so an inheritance may be in their future. They can come in different forms—possessions, real estate, financial assets (in taxable and tax-deferred accounts), a small business, or annuity or life insurance proceeds.
Some studies show that one-in-three households who receive an inheritance "blow it." But as Christians, when we receive a large lump sum, we must wisely steward it, remembering that it's God's money, not ours (Ps. 24:1).
I recently talked with a few different families about what to do with an inheritance generally (not mine, theirs'). A couple were pretty sizable (one is mid-six-figures and the other in the low millions).
Because there may be tax implications and many options for investing an inherited sum of money, it's often wise to seek professional advice (the larger the inheritance, the more likely you need guidance).
I don't give financial advice, at least not in the professional advisor sense; I mainly wanted to help them to understand the significant factors involved and some of their options.
Receiving an inheritance is like any windfall in many respects but different in others. In this article, I discuss these things in three main areas: taxes (estate tax, inheritance tax, and income tax), saving and investing, and giving (which may be applicable in any windfall situation).
Paying estate and inheritance taxes
The main thing to know here is the difference between estate and inheritance tax.
The estate tax is based on the net value of the property owned by the deceased. When it is transferred to a beneficiary (an individual, an organization, or a trust), the estate pays any tax due regardless of who inherits it. (Any debts or other liabilities must also be satisfied by the estate.)
The federal government imposes an estate tax on property valued at more than $12.06 million in 2022. Some states also have an estate tax, which would be in addition to the federal tax.
The inheritance tax is based on the value of individual bequests received by the deceased's beneficiaries. The beneficiaries are usually responsible for this tax unless the will stipulates that the estate pay them.
There is no federal tax on inheritances. However, an inheritance tax is imposed by some state governments, and the tax rate depends on who receives the property and, in some cases, how much. Fewer states have an inheritance tax than have an estate tax, and only one (Maryland) has both.
If you inherit a sizable estate, it would be wise to consult with a tax accountant and a financial planner to make sure you understand your tax obligations, if any (most people will owe no tax).
Paying income taxes
Beyond estate and inheritance taxes are the ongoing income tax considerations.
The proceeds from an estate or a financial inheritance will take two forms:
- tangible property assets (houses, land, jewelry, furnishings, etc.)
- financial assets in taxable and tax-deferred accounts (proceeds from liquidated real property, savings accounts, brokerage accounts, retirement accounts, etc.)
There are no immediate tax implications to inheriting a house or land unless the federal estate tax or state taxes apply. However, if you inherit a home and then sell it at a profit soon after, the IRS says you may owe taxes on any profit as ordinary income (not the difference between the deceased's cost basis and the sale price).
If you inherit financial assets that are not held in a retirement savings account, you will be responsible for taxes on any future income or capital gains you realize from them. For example, if you inherit shares of stock in a traditional brokerage account, the cost basis is their market value at the deceased time of death, not the original purchase price.
Also, if you own stocks that pay dividends or bonds that pay interest, those will usually be taxable, even if you reinvest them.
Two types of cash stock dividends are " qualified " and "ordinary." Qualified dividends are taxed at lower rates (as capital gains, normally at a rate of 15%) than ordinary dividends, which are considered ordinary income and taxed at your marginal income tax rate (which could be 22% or higher).
Most dividends are considered "ordinary" unless they qualify as "qualified." Interest from individual bonds or bond funds is taxed as "ordinary" dividends, as is interest from savings and credit union accounts.
Confused? This Investopedia article explains it well.
Inherited retirement account assets are treated differently. Moreover, the IRS rules were changed by the "SECURE and Care Acts" passed in 2019.
Your taxes on an inherited IRA will depend on your status as an "eligible" beneficiary (such as a surviving spouse) or are deemed "ineligible," such as an adult child or a grandchild.
Eligible beneficiaries are subject to the "old rules" that were in effect before 2020. That means they can choose to take ownership of the IRA (or roll it into their own existing IRS), take distributions, and pay taxes based on their own RMD schedule beginning at age 72.
Ineligible beneficiaries, on the other hand, are subject to the new rules, which essentially say that they must completely distribute the account and pay the taxes within ten years of the original owner's death, regardless of age. (This accelerates the rate at which the federal government receives its taxes.)
Early on, it was unclear what the IRS' specific withdrawal requirements would be for "ineligible" beneficiaries: Would they require annual RMDs (even withdrawals over the ten years) or allow periodic withdrawals of various amounts (including the withdrawal of the entire amount and payment of all taxes in year ten)?
It took two years, but the IRS finally issued guidelines in Feb. 2022 specifying the former (RMDs required over ten years) and, due to the delay of the ruling, recently said it would waive any penalties for missed RMDs for 2021 and 2022—delaying the RMD requirement until next year (2023).
Saving or investing
It would be best if you decided how to invest inherited financial assets in the larger context of your financial situation.
If you have little savings (short or long-term), you may view an inheritance much differently than someone with little or no debt and sufficient retirement savings.
The first thing to do may be to set aside an emergency fund of at least three to six months of income.
If you're dealing with a lot of debt, you may want to use some of your inheritance to pay down debt.
Other than the "sleep at night factor," as a general principle, if your interest charges are higher than what you can safely earn on the same amount (using CDs, a money market fund, or short-term treasuries), then it would be wise to pay off the debt.
Whether to invest or pay off a home mortgage is a more difficult question to answer. The math behind this decision—a classic tradeoff—is tricker than you may think.
We know this for sure: Paying off (or avoiding) a fixed-rate mortgage is a fixed and guaranteed return on your 'investment.' However, investing in stocks is volatile. And you elevate volatility risk when you "leverage" yourself—i.e., borrowing money (for any purpose) to maintain or increase your exposure to the stock market.
For many, the decision whether or not to pay off a mortgage will be based on factors having nothing to do with investing opportunities (e.g., risk aversion, personality, personal goals, tax implications, etc.
Also, if you don't have an emergency fund, it may be best to set that up too.
If you need to beef up your retirement, there are several ways to do that:
Add to your retirement savings accounts. If you don't already have them, you could open and fund IRAs for you and your spouse. (You must have the equivalent income to meet IRS requirements.) Or, you could use some of your inheritance to max out your existing IRA accounts, including the "catch-up contribution" if you're eligible.
It's more challenging with employer-sponsored plans.
Lump sum contributions to employer plans—401k, 403b, etc.—have to come from earnings from your employer, not from external funds. However, some plans will allow for a large percentage to be withheld from a single paycheck or the remaining paychecks for the current year, and for that time, you could live off the equivalent amount of the inheritance. The caveat is that you can't contribute more than you've earned.
Purchase an Annuity. The annuity world consists of many complex and sometimes high-cost products. But at their core, they're insurance products that pay out income.
In return for a lump sum, the insurance company makes payments to you immediately (an immediate income annuity) or in the future (a deferred income annuity).
Purchasing an annuity outside of a retirement account to provide additional income in retirement may be a wise decision if you're already maxing out your retirement account but are still concerned you won't have "enough."
If you decide to go this route, look for a simple, low-cost, immediate, or deferred-income product. (Guaranteed rates on the latter have risen as the Fed has increased interest rates.)
You also want to choose a product from an insurance company that is fiscally strong.
Unfortunately, inflation-adjusted income annuities are no longer available. However, you can purchase income annuities with payouts that increase a certain percentage each year (but will start lower).
Remember, in most cases, once you give the insurance company the money, it's gone—even if you don't live long enough to receive a single payment. Also, potential heirs aren't guaranteed anything unless there are specific policy terms to that effect.
Purchase Long-Term Care Coverage. There are two main ways of investing in long-term care coverage: a longevity annuity (see above) or long-term care insurance.
LTCI isn't like traditional health insurance—it's designed to cover the cost of long-term skilled and custodial care services in various settings (home, community organization, or care facility).
Traditional LTCI is a "use it or lose it" policy—if you don't need the service, you will get no use from the money you paid in policy premiums (except the knowledge that you could have used it if you did).
But if you think about it, that's the way most insurance works: we buy home insurance hoping we never have to file a claim (meaning we didn't experience a damaging or destructive event), but rest in the knowledge that we can should the need arise.
The good news is that other products can help address the need, such as a longevity annuity and, more recently, hybrid LTCI products that combine life and long-term care insurance.
Another (and perhaps best) use of an inheritance is to give some (or all) of it away.
This is, of course, a profoundly personal decision, but I think every Christian should consider giving some of the "firstfruits" of an inheritance to the Lord, at a minimum (Debt. 18:1-5, Prov. 3:9, 1 Tim. 6:17). For many, that will mean tithing it to their local church.
Beyond that, giving to a local organization that helps the poor, Christian missions, and other worthwhile organizations can be a God-honoring way to give.
Another option is to provide immediate assistance to family members (for example, helping with a student loan debt) or invest long-term on behalf of children or grandchildren.
The simplest way is an outright cash gift. You can give a grandchild up to $16,000 yearly (in 2022) without reporting the gifts to the IRS. (Married couples can each give up to the same amount.) So, a couple with three grandchildren could give $96,000 without any gift tax obligations.
Additionally, the gifts are not taxable as income to the grandchildren (although future earnings on them will be).
Another option is to contribute to an IRA on a child or grandchild's behalf. A child of any age can have a Roth IRA as long as they earn income from a job. You can provide money to contribute to the account, but it can't be more than what the IRA owner makes for the year.
Funding a 529 college savings plan can help a child or grandchild with future education expenses. According to Fidelity, these plans "offer an appealing combination of tax advantages, control, flexibility, and minimal impact on student aid." Contributions are after-tax but grow and can be withdrawn by the student tax-free.
If the inheritance is sizeable, and you want to donate most of it to ministries or charities, consider setting up a charitable trust.
Or if you want to give to family members but control the distributions in the future, including after you're gone, a revocable living trust may be the way to go. Talk to an attorney who specializes in estate planning and trusts to see what would be best for your situation.
At the heart of it all is generosity that comes from a heart of gratitude toward God for his many blessings, spiritual and material (Ps. 107:1, Js. 1:17, Eph. 5:20).