If a loved one has passed and you're expecting to receive an inheritance, you may have a number of questions about the process; such as is an inheritance taxable and what to do after receiving an inheritance. Whether an inheritance is taxable to you, the beneficiary, will depend on what type of asset you inherited. Determining the best use of inherited funds will require some financial planning to evaluate your goals, priorities, and analyze possible trade-offs.
Settling an estate
The process and timeframe for settling your loved one's estate (the decedent’s) will depend on how complex their financial life was and the organization of their affairs. An estate consists of all assets in which the individual had ownership interests, including financial accounts (retirement, banking, brokerage, etc.), real estate, personal assets, life insurance proceeds, businesses, and so on. These assets are then reduced by the decedent's share of outstanding debt, such as a mortgage and other types of loans. A complete inventory of all these assets must be made, which can take some time in a complex estate.
Beneficiaries typically do not receive any distributions until after the probate process is complete and any outstanding obligations of the estate are paid off.
The probate process
Probate is a legal process where certain assets in the decedent's estate that were owned as an individual are distributed by the court. How does the court decide who gets what? If there was a will, then assets are typically distributed accordingly. If the decedent did not have a will, then the court decides.
Does an inheritance go through probate?
Certain types of assets will not enter the probate process regardless of whether there was a will in place.
- Beneficiary designations: Assuming the decedent has made proper beneficiary designations, accounts like IRAs, 401(k)s, brokerage accounts, and life insurance policies will bypass probate.
- Trusts: Trusts will also bypass probate, which is one of the key reasons they are used in the estate planning process. Whether the decedent established a revocable or living trust during their lifetime, or the estate plan details that certain assets will pass to newly created trusts upon death, these assets may not be subject to probate. A wide range of assets can be placed in a trust - common examples include real estate, art, cash, investment accounts, and so on.
- Titling: Assets that are owned jointly, often by marriage, may pass to the spouse and avoid probate. States have different rules about ownership in this regard so it will ultimately depend on the state you live in and the physical location of the assets, if any.
If an inheritance does not fit these criteria, then it will likely pass through probate. Remember, having a will does not mean assets will avoid probate; a will is essentially a legal record of the decedent's wishes that will be used during the probate process.
What to do with an inheritance
Depending on your goals and what type of asset you inherited, your options may vary. For example, if the decedent put cash or securities in a trust for your benefit, they may also have defined the timing of distributions and/or what the proceeds can be used for. As there are an unlimited of possible situations in this regard, keep in mind that your inheritance may not have the same options as a cash inheritance or assets that can be easily liquidated for cash. To discuss what to do with your inheritance, please contact us directly.
Inheriting a home or other personal property
An inheritance or unexpected windfall can sometimes stir mixed emotions, particularly when the inherited asset is tangible personal property like a home. With an inherited home or other real property owned by the decedent, there's often an added level of complexity and nostalgia that typically isn't found with cash inheritances. At times, a beneficiary may put themselves in a strained financial position in an effort to keep an inherited family home, especially when it requires buying out co-beneficiaries (often siblings). Before letting emotions drive the strategy, try to take a more objective look at the situation and assess your means and the impact it may have on your other goals. Keep in mind the intent of your loved one also. They probably did not wish to cause you stress with this gesture, delay your retirement, or raid Junior's college fund.
Inheriting an IRA or retirement account
You may have several options after inheriting an IRA which will vary depending on your relation to the deceased, their age, your age, whether you inherited a traditional IRA or a Roth IRA, whether distributions have already begun, and so on. Tax-deferred accounts require additional tax planning to help ensure there are no unintended tax consequences from distributions. Since this type of inheritance is subject to income tax when withdrawals are made, you likely won't receive a lump sum to fund your other goals.
Inheriting cash or stocks in a brokerage account
Inheriting cash or another liquid investment like a brokerage account outright (e.g. not in trust) can provide a lot of flexibility for a beneficiary. Although the windfall may not be enough to fully fund all of your goals, it could be the jumpstart necessary to make reaching them possible. There are two common pitfalls to avoid when it comes to inheriting assets "free and clear." First, there's a frequent temptation to spend the proceeds on a new home or other personal property instead of saving and investing for larger financial goals. Second, individuals may also become nostalgic about certain inherited securities, typically single stocks, and reluctant to sell them. Single stocks carry a much greater investment risk than a diversified portfolio would, so balancing risk tolerance with your emotions and overall investment management strategy is important.
When deciding what to do with an inheritance or windfall, consider working with a financial advisor who can help you objectively evaluate your options and also understand the emotional dynamic involved. When we develop a financial plan for our clients, we combine all the pieces of their financial and life situation to create one cohesive view. Using income, fixed expenses and other discretionary spending data, we are able to project clients’ cash flows. Through modeling, we can help you prioritize goals and evaluate trade-offs by developing what-if scenarios complete with a timeline and funding projections. Instead of going it blind, you can make an informed decision based on actionable data.