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Inherit a Windfall Without the Pitfalls


August 17, 2006

Read Time

8 minutes


As parents live longer, many adult children can expect to receive an inheritance later in their own lives-in their late fifties and sixties, and even in their early seventies. Baby-boomers alone could come into $7.2 trillion, according to Boston College's Center on Wealth and Philanthropy.

The new wealth presents an opportunity for adult children. The possibilities are many – whether it's to improve their own retirement, pay down debt, give gifts to their children and charity, or pursue new interests.

But it's easy for beneficiaries to botch the best-laid plans of Mom and Dad. The complicated laws governing retirement plans and investments, plus the complexity of the tax system, create a minefield that most heirs can't easily traverse.

If you inherit money, there are steps you can take to avoid some of the pitfalls and make the most of your parents' financial legacy.

Chill Out
One of the best moves a new heir can make is to do nothing at all for a while, except for meeting some legal deadlines. If you act haphazardly, you could end up with an IRS bill or a fancy car you don't need. "At the most, take a small percentage and go on a special trip, but use a year to meet with professionals and study the options," says Thayer Cheatham Willis, author of Navigating the Dark Side of Wealth: A Life Guide for Inheritors (New Concord Press, $25). "An investment opportunity may look compelling, but there will be other ones."

Susan Bradley, a certified financial planner in Palm Beach Gardens, Fla., calls this time "a decision-free zone." Bradley, who heads the Sudden Money Institute (, which provides financial and emotional advice to those who receive inheritances and other windfalls, suggests that the money be kept apart from all other assets. Don't put it in a checking account, she warns. "Open a separate account in your own name, and put the money in low-risk investments–maybe short-term municipal bonds or Treasuries," she says. "Then take a look at all areas of your life."

Treat inherited retirement plans carefully
Inherited IRAs are a danger zone for nonspouse beneficiaries. Under tax laws, a nonspouse heir of an IRA can keep the money in a tax-deferred retirement account and stretch out distributions, as well as the taxes, over a lifetime. But a beneficiary can lose a big chunk of the money to taxes if an adviser doesn't follow all of the intricate rules governing IRAs.

The most important rule: Make sure the adviser does not liquidate the account and cut you a check. If that happens, you will have to pay income tax on the entire distribution at once and lose all chance for decades of tax-deferred growth.

Also, unless you're the spouse of the deceased IRA owner, you're not allowed to roll the inherited IRA into your own IRA. The IRA must be maintained as an inherited IRA and the name of the person who left it to you must remain on the account, according to Ed Slott, a certified public accountant in Rockville Centre, N.Y. For example, Slott says, if the IRA owner was Fred Jackson and the beneficiary is his daughter, Sandra Jackson, the inherited IRA should be titled: "Fred Jackson, IRA (deceased June 19, 2005) F/B/O Sandra Jackson, beneficiary." FBO is "for the benefit of."

Starting next year, the recently passed pension law will allow a beneficiary of a 401(k) or 403(b) plan to transfer assets to an IRA and take distributions based on his or her own life expectancy (see "Pension Law Filled With Treats for Savers," on page 5).

Check for income taxes. Many heirs do not realize that they could owe income taxes on a part of the non-IRA inheritance, says Robert Romanoff, who heads the Asset Planning and Preservation Services Group at the law firm of Levenfeld Pearlstein, in Chicago. "People need to ask if the money is subject to income tax," he says. "They often get the distribution and say, 'Terrific.' A year later, they get an income reporting statement from the executor in the mail notifying them that a portion was income."

Romanoff offers an example: Say Uncle Joe leaves you one-fourth of his estate. Before you get your share, the money sits in a bank earning interest. If the executor cuts you a check for $500,000 before paying taxes on this interest income, Romanoff says you'll be on the hook for taxes on the interest portion of the inheritance.

An heir could also owe taxes on proceeds from an installment contract, Romanoff says. Assume Uncle Joe sold a business or his partnership interest in a firm, and his payments from the buyer were to be paid in yearly installments over five years. If Uncle Joe dies before the five years are up, the subsequent payments will go to the estate. If the estate does not pay tax on this income before you get a distribution, you'll be responsible for the tax for your share.

Turn down the money
Although your first inclination may be to grab the money, estate-planning experts say there are times when "disclaiming"–that is, refusing–all or part of the inheritance is a wise move. If you don't need the assets, you can file a qualified disclaimer and the money could perhaps go directly to your children, if they're named in your parents' will as contingent beneficiaries. The disclaimed portion will not count against your $1 million lifetime gift-tax exemption or your $2 million estate-tax exemption. "If I give $1 million to my kids, I use up my lifetime exemption. But if I disclaim $1 million, I can still give them another $1 million," says Stephen Silverberg, a partner with Certilman Balin Adler & Hyman, in East Meadow, N.Y.

However, a nonspouse beneficiary cannot direct where the disclaimed property goes, says Silverberg. In the will, the person leaving the money must name a secondary beneficiary who would get the assets if you disclaim. So if you're thinking of disclaiming, it's a good idea to talk about it with your parents. You can always change your mind later and keep all or part of the inheritance.

But Silverberg warns that the rules governing disclaimers are complex. You can disclaim a percentage of your inheritance, a dollar amount or specified assets. But if you take even a $100 dividend check before you file a disclaimer, you lose the opportunity to disclaim any of the assets. Also, the notice must be filed within nine months after the benefactor's death Make sure you seek advice from an estate-planning lawyer quickly if you're considering this option.

Reassess your investment strategy
Receiving an inheritance could prompt changes to your portfolio. You can sell off appreciated stocks and real estate from an inheritance without having to pay capital-gains tax. Heirs receive a "step up" in basis on inherited property–that is, any gain is calculated on the growth of the asset after the benefactor's death, not on when the asset was originally purchased.

"You're starting with a clean slate," says Kevin Dorwin, a certified financial planner with Bingham, Osborn & Scarborough, a wealth-management firm in San Francisco. "You don't have to make decisions based on capital gains." For instance, if the stocks were not inherited, an investor who wants to sell off stocks to rebalance a portfolio would have to pay taxes on any gain. But an heir could sell inherited stocks and buy fixed-income investments to balance the portfolio without any tax consequences.

Seth Pearson, a certified financial planner with Pearson Financial Services, in Dennis, Mass., says heirs should not view the inheritance as "a reason to take a two-year trip around the world." In most cases, he says, a 60- or 65-year-old person who receives an inheritance should use the money for retirement. "Add it to your portfolio and stick to a withdrawal strategy of 4% plus inflation," he says.

Understand the emotional side
Heirs also need to deal with the emotional, as well as the financial, aspects of newfound money. Sudden Money Institute's Bradley says the death of a parent and an inheritance are "major life transitional events." Some beneficiaries want to use the new wealth to fulfill personal goals, while others need to figure out how their spouses should share in the wealth.

Some heirs worry about whether they can meet their parents' expectations for guarding the money. Consider Nancy, 72, of Cape Cod, Mass., who inherited a sizable estate from her 98-year-old father when he died earlier this year. (She requested that her last name be withheld to avoid solicitations.) She recalls that when she was a child living in Michigan, her parents, who each bought their favorite stocks, would discuss their investments at the breakfast table. "They would kid each other about whose stocks were going up faster," she says. Nancy found it difficult to sell the stocks after her father died. "I had a sentimental attachment to them," she says. "I didn't want to make any mistakes. I wanted to protect their money."

Pearson, her financial planner, persuaded her to invest in a diversified portfolio of index mutual funds. "I decided that the biggest way I could honor my parents was to let this money grow," she says.

Filed under: Trusts & Estates

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