Despite our dreams, we are unlikely to win a big lottery and only a relatively small group will cash in on the sale of a business, but we are in the midst of the largest wealth transfer in history as many baby boomers will receive inheritances from their hard working, successful and savings orientated parents. Thus, a fair number may be dealing with a material inheritance. Usually, the heirs are aware of the likelihood of a bequest but perhaps not its size and, sadly, not the timing. Inheritances are often sudden.
Like any other sudden increase in wealth, you need to evaluate carefully your new financial position and consider how your rapid wealth increase will affect your financial and, importantly, your life goals. You also need to assess that additional wealth’s impact on your insurance (increase to umbrella, life and/or property and casualty), your own estate plan (to encompass your new assets) and possibly charitable gifting. And, of course, consider the tax consequences of your inheritance, among other issues. So you don’t want to rush out and impulsively buy that new and expensive ‘just gotta have’ item. Take a deep breath first because you have some homework ahead of you.
Unique Issues that arise with an inheritance
With an inheritance your planning will partly depend on whether you have immediate access to, and total control over, the assets, or if they're being held in trust for you. In addition, you need to know what types of assets you inherited (e.g., cash, property, or a portfolio of stocks). If you have recently received a bequest and your inheritance was large in comparison with that received by other beneficiaries, consider the possibility that the Will may be contested.
Inheriting assets through a trust vs. inheriting assets outright
When you inherit money and assets through a trust, you will receive distributions according to the terms of the trust. You won't have total control over your inheritance as you would if you inherited the assets outright. The trust document may spell out how the trust assets will be managed and how and when trust income and assets will be paid to you, and it will outline the duties of the trustee. These clauses are designed to keep what is often referred to as ‘motorcycle money’ out of the control of those too young to handle large sums. Baby boomers are likely past the typical ages used in trusts for this purpose but there may have been other reasons to limit, or otherwise time the distribution to you.
Know the terms of the trust
If you are the beneficiary of a trust, you should do the following to ensure that your interests are protected:
- Read the trust document carefully. Go over the document yourself and with the help of a legal or financial professional, making sure you understand the language of the trust and how its income and principal will be distributed to you.
- Determine if the trust income is sufficient to meet your needs. For example, is the trust heavily invested in long-term growth stocks or non-rental real estate? Alternatively, is the trust invested in things that provide income to you now, such as rental real estate or money market funds?
- Pay close attention to how the trustee handles the investments. Have your financial advisor look over the trustee's investment strategy. If your advisor determines that the trustee's investment strategy doesn't meet your needs or, worse, is unsound in comparison to your individual risk tolerance, discuss this with the trustee.
- Trustees are often difficult to replace, and although they're not supposed to lose money on investments, they're not usually penalized if the trust performs poorly. If you decide to sue the trustee for mismanaging the trust, his or her legal fees may be paid for from the trust.
- Get to know your trust officers (if any) and find out how much the trustee fees are. Then, compare the fee with the average in your state or county (you might ask your local bank for this information). You may be able to renegotiate the fee if it is too high, especially if the estate is large.
If you inherit stock, is it through a trust or outright? The major question to consider is whether you should hold or sell the stock. This depends on your overall investment strategy and, importantly, what type of stock you have acquired. If you acquire stock in a company, for example, and you now own a controlling interest, you need to look at how actively you want to be involved in the company or how much you know about the company.
Inheriting real estate
If you inherit real estate, such as a house or land, again you probably have to decide whether to keep it or sell it. If you keep it, will you live there or rent it out? Do you hope that the house will appreciate in value, or are you keeping it for sentimental reasons? If you decide to sell or rent the house, you'll need to consider the tax consequences, as well.
Income tax considerations
In general, you should not directly owe income tax on inherited assets. However, a large inheritance may mean that your income tax liability will eventually increase. Income from those assets may be subject to income tax. Once you increase your wealth, you should look at ways to minimize your overall tax liability, such as shifting income, giving money to individuals or charity, utilizing other income tax reduction strategies, and investing for growth rather than income. You may also need to re-evaluate your income tax withholding or estimated tax payments.
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From this brief overview, it’s easy to see why inherited wealth is considerably more complex that most other forms of sudden wealth. If you do inherit material amounts of assets, I encourage you to seek the advice of competent professional advisors.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual, nor intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.