The Wealth AdvisorContributor
April 19, 2021
The following information was developed by Financial Planning, an independent third party. The opinions are of the listed author and are independent from and not necessarily those of RJFS or Raymond James. Neither Raymond James Financial Services nor any Raymond James Financial Advisor renders advice on tax issues, these matters should be discussed with the appropriate professional.
You have just received an inheritance. What do you do now? You could spend it on some extravagance, but you would be better off doing two things first: assessing the tax ramifications and thinking about some investment options.
“Death taxes” are somewhat misunderstood, as people can find the two types of death taxes confusing. Estate taxes apply to the front end of the wealth transfer process and are subtracted from the overall value of the estate. They only apply to huge estates and reduce the size of your inheritance upfront; you have no further tax obligation. The Tax Cuts and Jobs Act (TCJA) increased the estate tax lifetime exemption amounts to $11.58 million for single filers and $23.16 million for married couples filing jointly in tax year 2020.
Inheritance taxes, where they exist, apply to recipients. There are no federal inheritance taxes, and only six states impose inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
State inheritance taxes depend on income as well as the inheritor’s relationship to the deceased. Taxes are applied on a sliding scale from one to eighteen percent. Even though it applies to the recipient of the inheritance, the tax is applied based on where the deceased lived — so you must check the state laws there to see if you owe any state inheritance taxes.
Income tax does not apply to inherited cash or assets, but non-cash assets will be subject to tax whenever they are sold. The basis of the sold asset is stepped up to the value at the time of death — in other words, if you inherit your parent’s house and sell it one year later, the capital gain or loss that affects your taxes is based on that one-year change in value. Otherwise, you would be forced to pay capital gains on the change in value between the sale date and when your parents bought the house, adding thousands to your tax bill.
The rules are slightly different among the different non-cash assets. For savings bonds, the only taxes you will owe are on the interest accrued during the decedent’s life (assuming that interest reporting was deferred until redemption). Inherited annuities accrue taxes at the ordinary tax rate, but the exact amount and timing of payment depend on the type of annuity (employer-based or private), the annuity terms, and whether distributions have started. The issuer of the annuity will have the relevant details.
The strategy for inherited retirement accounts (401(k)s and IRAs) depends on your relationship with the deceased and your respective ages.
- You and Deceased Spouse Are over 70-½ – Minimum distributions have already started. You can leave things as is and receive the distributions, roll it into an inherited IRA or roll it into your own spousal IRA — usually the least painful choice for the next generation after you pass away. Since January 1st, 2020, the age for minimum distributions to begin was increased to 72.
- You Are a Spouse Age 59-½ to 70-½ – The same options apply, but the spousal option is better still, since you can delay distributions until 70-½ (age 72 from 2020 onwards).
- You Are a Spouse under Age 59-½ – In this case, the situation is reversed. Early distributions are subject to a 10% penalty under the spousal IRA, but not under the other options.
- You Are a Non-Spouse – If you are not the spouse of the original IRA owner, you cannot treat the IRA as your own. You can thus not roll over funds into or out of the inherited IRA or make any further contributions to the IRA. You won’t owe tax on any assets in the IRA until you start receiving distributions from it.
Once the inheritance and tax issues are dealt with, you can move on to what to do with your inherited windfall. Cash inheritances are best used to address any high-interest bills (credit cards are an example) or to pay down mortgage debt by making extra payments against principal. Consider creating an emergency fund as well.
If you have not maxed out your IRA or 401(k) contributions, now is the time. Any leftover funds should be placed in liquid investments like money markets or laddered CDs to give you time to lay out an investment plan unless you have other specific investment needs, like a 529 college plan for your kids. Thanks to the TCJA, you can now also use 529 plans to accumulate tax-free savings for public or private elementary and high school costs, up to $10,000 per year, as well as college. CDs are insured by the FDIC and offer a fixed rate of return, whereas the return and principal value of investment securities fluctuate with changes in market conditions. As with other investments, there are generally fees and expenses associated with participation in a 529 plan. There is also a risk that these plans may lose money or not perform well enough to cover college costs as anticipated. Most states offer their own 529 programs, which may provide advantages and benefits exclusively for their residents. The tax implications can vary significantly from state to state.
Inherited assets like stocks or real estate should be integrated into your portfolio and should then be rebalanced to return to your risk profile. That may require selling some of the stock you already own or the stock you inherited to manage your risk. Rebalancing a non-retirement account could be a taxable event that may increase your tax liability.
With prudent planning, you can make the most out of your inheritance. Resist the urge to splurge and you will be thankful later.
The IRS and Treasury Department have extended the 2021 tax filing deadline from April 15 to May 17, due to the COVID-19 pandemic. In the interest of safety and to curb the spread of the coronavirus, all Taxpayer Assistance Centers (TAC) and face-to-face IRS services operate by appointment only. Taxpayers can call 844-545-5640 to schedule an appointment or find your local IRS TAC here. See the IRS Coronavirus Tax Relief page for the latest updates.
Failing to pay your taxes or a penalty you owe could negatively impact your credit score. You can check your credit score and read your credit report for free within minutes by joining MoneyTips.
This article originally appeared on Mass Live.