Receiving a sudden financial windfall through an inheritance can lead to some very mixed feelings. On the one hand, you may have just experienced a loss that is emotionally devastating. On the other, the money you receive might be able to relieve some of your current financial stresses.
It might be hard to think through all the logistics of inheritance best practices, when you are actually faced with this situation, because emotions can run high. Ahead of time, it’s a good idea to do some strategic planning – whether you’re the one leaving or receiving an inheritance.
Don’t spend it all at once
An inheritance – even if it’s only $10,000 or $20,000 – can be a tempting source of funds to splurge with; especially for someone not used to having so much money all in one place. This money is easy to squander.
Consider putting the money aside for six months to a year, in an interest-bearing account, to give yourself time to digest both your loss and the influx of cash. Later, when the rush of emotion passes, you’ll be in a better state of mind to decide what to do with the money.
Should you keep it separate?
Inheritances are generally considered each person’s own personal property Opens in new window, and spouses usually may not lay claim to it. However, commingling the money with other marital assets can undo those protections. (For example, if you receive cash from Aunt Betty and deposit it in a joint account with both spouses' names, it’s considered commingled.)
In community-property states – Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin – your spouse is entitled to half of all the marital assets in the event of divorce. In the other states, a judge will decide how much of the marital assets each spouse is entitled to.
If your intention is to keep your inheritance to yourself, you may want to consider putting it in a separate account under just your own name. Since laws vary by state do your research and consider speaking with a legal professional.
Consider building a trust to help protect special benefits
When Ed Busansky’s daughter, Sarah, was born with cerebral palsy, he made sure she received all the government assistance she could. By his estimate, Sarah – now 17 and soon to start college – has received close to $1 million in medical care and special equipment, through the years.
Ed, who lives in Tampa, Florida, had some worries about what might happen when Sarah receives an inheritance from relatives, along with the proceeds of his life insurance policy. The money, combined with other assets, could push her above the eligibility threshold for Medicaid.
To combat this concern, Ed created a special-needs trust, which is a specific type of trust whose assets can be used to pay for equipment, caregiving and medical assistance without affecting a person’s eligibility for public programs. Any money Sarah receives, including inheritances and life insurance, will go into the trust, not to her personally.
Explore all IRA options
Inheriting an IRA is not as straightforward as getting cash. In the case of a traditional IRA, you’ll have to pay taxes, though it’s possible to manage this in a tax-efficient way.
Though you may cash out an inherited IRA immediately (and pay taxes), you may also stretch out the distributions from the account. Though you’ll owe taxes each year on the distributions, there is the potential for tax savings by not bunching all of the income into one year and enables the account to maintain its potential to grow tax deferred. For deaths of the IRA owner occurring before 2020, you can spread the distributions over your lifetime. If the death of the IRA owner occurred after 2019, you are generally limited to a 10 year payout. If you are an Eligible Designated Beneficiary, then even if the owner died after 2019, you are eligible to use a lifetime spread. An Eligible Designated Beneficiary includes the owner’s spouse, the owner’s minor child (who must begin a 10-year payout stretch upon reaching majority), a disabled or chronically ill individual, and a beneficiary less than 10 years younger than the IRA owner.
Bear in mind that the penalty for not taking a required minimum distribution is a stiff 50% on the amount that should have been withdrawn.
Have a separate retirement strategy
An inheritance is not a retirement plan. Life is unpredictable…so you should never count on getting that money, even if you have been told it will go to you.
First off, your parents or other loved ones may end up running through all their money if they live to a ripe old age and require a lot of end-of-life care. Or they may have a change of heart about their money, opting to leave it to another relative or fund a philanthropic endeavor.
What you can do next
Just as Ed Busansky did for his daughter, it’s important to think through all the factors involving an inheritance – either one you will be giving or one you may be receiving – well in advance. This kind of planning can help prevent some regrettable decisions that can be made during an emotional time. By taking steps now, Ed has been able to sidestep a common inheritance mistake: not integrating inheritance into an overall financial strategy. While most people know that large estates need special attention, fewer realize that more modest sums of money do too.
Please consult your tax and legal advisors regarding your particular circumstances.