WASHINGTON — Receiving an inheritance may come with a mix of conflicting emotions.
Depending on the amount of the assets and your overall level of wealth, the impact of receiving an inheritance can range from a minor change in your tax liability to a major change in your lifestyle. For the first time in your life, you might need help determining how the new source of wealth will impact your near- and longer-range financial plan.
There’s a lot for beneficiaries to consider when it comes to understanding and navigating the complicated tax implications of receiving an inheritance.
When analyzing your options for an inherited IRA, keep in mind that the tax rules differ depending on whether the beneficiary is a spouse or a non-spouse. For now, I am focusing on non-spouse beneficiaries, such as children or grandchildren, and the rules that pertain to them. If you are one of these IRA inheritors, it’s good to know these rules to avoid having to pay substantially higher income taxes, and, ultimately, to keep more of your inheritance.
To simplify the decision-making process, I outline the pros and cons of two potential choices — either selling the assets and taking a lump sum withdrawal, or keeping the account invested. While some wealthier inheritors of IRAs ask if they can convert assets to a Roth IRA, that option is only available if the spouse inherits the assets.
Choice No. 1: Take a lump sum withdrawal
Receiving a windfall by way of an inheritance may give you the breathing room to make a large purchase, such as a home; to upgrade your home with much-needed renovations; or to take your dream vacation. Before you decide to cash in some or all of your inheritance, there are two important considerations: the income tax implications and the risk of comingling your inheritance.
Be prepared to pay substantially more taxes
Withdrawals from an IRA account, whether an inherited IRA or a regular IRA, are taxed as ordinary income for the year of withdrawal. That means they do not have the benefit of being taxed at the lower capital gains tax rates (currently zero, 15 or 20 percent, depending on your tax bracket). You’ll want to consider this if you plan to liquidate your entire inherited IRA account, because the value of the assets will increase your taxable income in the year you sell the assets and take the funds.
If you have other taxable events in that same tax year (i.e., taxable inherited assets like an annuity, or other income events) you may be pushed into a higher overall tax bracket. Without considering your total taxable income, you may end up paying more income tax than you expect.
Ways to reduce the chance of hitting a higher marginal tax bracket include splitting the withdrawal into different tax years or taking funds out of the inherited IRA in a more favorable income tax year. Unless you have a low income tax year, taking a lump sum may not be the most tax-efficient way to receive your inherited assets.
Keep your inheritances as separate property
If you decide to take a distribution from your inherited IRA, you’ll need to determine where to deposit the cash proceeds. If you are married, we recommend you segregate money into an account titled in your own individual name. This is important to protect your inheritance should you get a divorce at any time during the rest of your life.
While the regulations vary by state, once inherited funds are comingled into a jointly held account, they become marital property that could end up in your ex-spouse’s pocket. Take care when using your inheritance to make home improvements or purchase property. If that property is titled with your spouse, you may end up converting the assets into marital assets by virtue of it becoming part of the equity in the home.
One related note, if you happen to inherit assets prior to marrying, we suggest you specifically identify those assets in a prenuptial agreement prior to your marriage in order to have clarity on ownership and title in case of a future divorce. While this may sound dire, we’ve seen these situations happen all too often. It’s better to know your options and potential consequences to your decisions before making them.
Choice No. 2: Keep the account invested
If you want to avoid the immediate tax burden triggered by a lump sum withdrawal from the inherited IRA, or if you don’t need the money now, you can keep the assets invested. An advantage of this approach is that the inheritance will continue to grow tax free. However, this will trigger rules that require mandatory distributions from the account over time.
Most beneficiaries should consult with a tax adviser to understand these annual required minimum distributions. The rules can get complicated and are impacted by factors, including: your age; the number of account beneficiaries; whether the inheritance was received as a direct beneficiary or by will; the age of the deceased; and whether the deceased met the required distribution for the current year.
You’ll want to work with an adviser who has all the facts of the situation, to ensure that you meet the tax regulations and avoid IRS penalties.
Adjust investments based on your goals and time horizon
When keeping an inherited IRA, it’s also important to consider the investment allocation of the account.
For example, when inheriting assets from an older individual such as a grandparent, we often see that the allocation is too conservative for the younger beneficiary. If you intend to keep the funds invested for the long term, you may want to consider taking on more investment risk as you have a longer time horizon than the original account holder.
You will also need to determine who will manage and monitor the account for you. Does the inheritance represent a significant portion of your overall wealth? Are you willing and able to invest and manage the account for yourself? These considerations will help you determine whether to hire an adviser to manage the account for you.
Be careful when titling your inherited IRA account
If you decide to keep the inherited IRA invested, then you will need to make sure that it is titled correctly and designate your own beneficiaries.
There are strict IRS rules on how to title an inherited IRA, including reflecting the name of the deceased and indicating that it’s an inherited IRA when you title the new account. If there are multiple beneficiaries of the original IRA (and there often are), you’ll want to inform the estate administrator that you are establishing a separate IRA account to receive your inheritance.
This is a critical detail. If it’s missed during the estate settlement, then your inheritance could become fully taxable, or your minimum distributions might be determined based on the life expectancy of the oldest beneficiary. In either case, your personal taxes will be impacted, which will reduce your total net inheritance.
Once you establish a segregated account for your inherited IRA, there’s one more important detail to consider—who will receive the account upon your death. That can be as easy as completing a beneficiary designation form for the account. Before doing so, you may want to contact your investment adviser, CPA, or estate attorney, as your beneficiary designation decisions can have important tax and estate-planning implications.
Receiving an inheritance is a remarkable gift — a legacy left by someone to you. If you receive an inherited IRA, keep this advice in mind, so that you will have more or your inheritance to enjoy or to pass on to someone you care about in the future.