Fidelity Outlook Magazine
How to Handle an Inheritance
For parents considering investing in a 529 college savings plan, the choices have never been greater – and the process of picking the right one more confusing.
“I never thought I would get an inheritance,” confesses Sandra Campbell, so the 53-year-old government worker was unprepared for the choices that confronted her when her father died. “I’d never say that money is a burden but trying to make decisions that I’d never made before was taxing.” For example, should she keep stocks that were her father’s sentimental favorites – even though their value was plummeting? Or would her father have been upset that she hadn’t sold them earlier? Every decision tripped an emotional minefield, Campbell remembers. “You don’t want to do the wrong thing.”
An inheritance can be both an asset and a liability. Depending on its size, an inheritance can enable you to pay off your debts, cover the kids’ college tuition, make a significant contribution to your retirement account or even retire early. On the other hand, almost no one is prepared for the chaos that the process of handling even a small inheritance can wreak on their personal finances and private life.
“As an inheritor, you need to understand what happens with the estate before you receive it, and then what happens when you receive it,” says Michael Murphy, vice president of estate planning for Fidelity. Otherwise, you’re in for some nasty surprises. Among them:
Surprise #1: The process may take a lot longer than you might expect.
Sandra Campbell’s father was a model of organization: He had set up a living trust for his three adult children (he was a widower) and put together a white notebook labeled “Sprague Family Trust,” in which he listed comprehensive information about his assets, “with dividers and names and everything,” recalls Sandra. Even so, it took nine months before the estate was settled enough to make an initial distribution of approximately $125,000 per child, and Sandra anticipates that it will be at least another couple of years before all the taxes are paid and the trust finally dissolved. “It was amazing that he could be that organized and there was still so much paperwork to file,” she said.
Zane Sprague further simplified matters by creating a pour-over, or testamentary, trust; upon his death, any miscellaneous assets not covered by the trust were immediately poured into the trust, avoiding probate. Still, there’s no short-cut through the paper trail, say most financial advisers.
Although it’s possible to start receiving distributions from the trust the day after the benefactor’s death, typically no distributions are made until after the estate taxes are paid – and estate taxes don’t need to be paid until nine months after the date of death. Furthermore, points out Deborah Segal, chief fiduciary officer of Fidelity Personal Trust, many attorneys advise executors not to pay anything until they receive a closing letter from the Internal Revenue Service stating that no additional taxes need to be paid. That’s a process that often takes another three months. “You can’t think, ‘Great, he’s dead, I’m getting my money,’” says Segal. “People typically don’t get their distributions for a year.”
Surprise #2: There may not be as much money as you expected.
Settling an estate costs money. For estates over $675,000 in value, Federal estate taxes can run anywhere from 37% up to 55% for estates over $3 million. Several states also levy an inheritance tax. There are fees for the lawyers, the executor and, perhaps, the accountant.
Medical bills can also take a big bite out of a bank account. “If your parents live to be very old, or they need to go into a hospital or nursing home, there may not be much left,” warns Barbara Blouin, co-founder of the Inheritance Project.
Then there are the ordinary bills and debts associated with the estate. Say you’ve inherited a parent’s house or the family summer home. “The estate is obligated to pay the mortgage and the taxes” on the property, explains Murphy. “You might be forced to sell the property just to pay any debt on it, or be forced to use your own money to pay the debt if you want to keep that property.”
In short, warns Murphy, “When you first hear the news, do not buy a new house.” It’s best not to make any change in your lifestyle until you’ve actually received the check.
Surprise #3: The assets may not be in the form of cash or securities.
You might inherit your grandmother’s 20-piece antique Russian silver tea set, a coin or stamp collection, a valuable painting, a house or even a business. Not only are these difficult to divide up among the heirs; they’re also considered part of the estate, so you will need to have them valued and then pay estate taxes on them.
If there’s not enough liquidity in the estate to pay the taxes, you have two options, neither of them pleasant: either pay the taxes from your own savings and get reimbursed later, or sell the illiquid assets—often at fire sale prices to make the nine-month deadline from the date of death.
Life insurance can often come to the rescue. Although the value of the policy is included in the estate of the decedent, the proceeds (minus the estate tax) pass directly to the beneficiary, providing cash in a crunch.
If there’s time for advance planning, there are even better forms of protection. An irrevocable life insurance trust shelters life insurance proceeds from estate taxes. As long as at least three years have passed between when the trust was created and the parent dies, the children don’t have to pay estate taxes on the proceeds because the parent didn’t “own” the policy within 36 months of his or her death.
If your parents’ most valuable asset is their house, they can shelter it in a Qualified Personal Residence Trust (QRPT), which enables them to put their house in trust for a specified period while retaining the right to live in it. After the period expires, the trust transfers ownership of the house to the designated family member. When the grantor dies, the house escapes estate taxes because it was already given away. When the heirs ultimately sell the house, they will pay a capital gains tax—but that will likely be much lower than the estate tax would have been.
Surprise #4: You may have to pay taxes on your inheritance.
If you’re the beneficiary of a qualified savings plan, such as an IRA, 401(k) or tax-deferred annuity, you’re in for a double whammy. The assets in the plan are included in the value of the estate, which raises the amount that can be taxed, and when you inherit the assets, you have to pay income tax on them at your own tax rate. If you think about it, it’s actually quite fair: after all, the money—technically referred to as “income in respect of a decedent”—has been accumulating tax-free. Still, says Segal, “the IRA inheritance is the nastiest surprise.”
An increasingly popular way to minimize the taxes on an IRA while still preserving its tax-deferred benefits is for the benefactor to set up a stretch IRA. Until recently, the beneficiary of an IRA was forced to pay taxes on the lump sum of the bequest. With a stretch IRA, the pay-out can be lengthened to stretch over the lifetime of the beneficiary. The beneficiary still has to pay taxes on the minimum required distribution but because the MRD is stretched, its amount—and the amount of the taxes due—is much less. Meanwhile, the remainder of the inherited IRA, as well as the beneficiary’s own IRA, can continue to grow tax-deferred.
Another option: Charitable contributions are not considered part of the taxable estate, so one way to avoid taxes on an IRA, especially one with a highly appreciated stock portfolio, is to turn it into a charitable trust.
Surprise #5: Your mind has turned to mush.
Give grief its due, experts urge. “The key thing to understand about grief is that you’re going to experience confusion and will not make good decisions about all kinds of things, including your finances,” says Michael Alexander, author of How to Inherit Money: A guide to making good financial decisions after losing someone you love (HarperBusiness).
His own story is a case in point. Alexander had a lot of experience managing financial assets that supplemented the income he made as a lawyer. Yet when his grandmother and mother died within months of each other when he was 31, he recalls, “everything went awry. Because my judgement was skewed by the grieving process, I made all kinds of little mistakes and one big mistake.”
Alexander’s grandmother had collected antique sterling silver. Alexander listened to a family friend, who counseled selling the most valuable pieces, claiming, “A young man doesn’t really need those things.” After auctioning off the items, Alexander mentioned the sale to another family friend. She was appalled: “Money comes and goes,” she said, “but you can never get back your precious family possessions.” Recalls Alexander, “I felt that I’d betrayed my grandmother by selling possessions that she had valued above others.”
That wasn’t the worst mistake Alexander made, though. Bad tax advice from the company that managed his grandmother and mother’s trust cost him $300,000. In retrospect, Alexander couldn’t understand why he didn’t follow his usual habit of getting second and third opinions. “What was I thinking that I took important advice from trustees whom I had never trusted anyway? That’s where I can see that I wasn’t thinking clearly.”
“You’re in a vulnerable period and you need time to get over that initial emotional reaction,” says Dan Rottenberg, author of The Inheritor’s Handbook: A definitive guide to beneficiaries (Simon & Schuster). That’s why many experts advise that the best immediate course of action with your inheritance is inaction. “Buy yourself time to make the decisions,” says Andus Baker, senior vice president of Fidelity’s private wealth management group. If you can afford to, stash the cash in a safe haven—such as certificates of deposit, Treasury bills or a money market account. Then do nothing until you feel you’re ready to deal with it.
Meanwhile, you’ll definitely want to talk with a lawyer and a financial advisor to get an idea of what you can do with your inheritance. You may also want to consult an accountant to understand how your tax situation has changed, and an insurance agent to protect your new assets. And don’t forget some of the most important players: your own children.
The emotional maelstrom churned up by an inheritance doesn’t mean that you shouldn’t enjoy it. For many people, spending a part of the money on something special is a way to commemorate their loved one. When Patricia Greene, 88, inherited a hefty hunk of money from her sister Margot, she first thought of buying a snappy car. But then she remembered that her sister loved to travel. “I thought, wouldn’t it be nice to give my children and grandchildren money to travel with in memory of my sister?” The result: They each got a $1,000 travel stipend and the entire family – all 25 of them – rented a French chateau for a week. “I could have just given them each $1,000 but then it would go for orthodonture or to pay for the roof. This was something they will remember forever.”