A letter shows up in the mail one day from a lawyer. Great Uncle Tybalt, who you haven’t seen since you were a tiny tot, died recently, and left you a sizable sum of money as an heir to his estate. A fantastic windfall indeed. Your first step is likely to be heading over to your financial planner to decide what to do with your newfound money. Let’s look at what inheritance is, how it is taxed, and how you can create a trust fund or inheritance of your own for future generations.
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What is Inheritance?
Inheritance is generally money left to you by someone in a will. This is an overbroad definition, but the money itself can come in a few different ways, from a trust, an IRA (individual retirement account), or just plain cash.
Cash is just that – cold, hard cash, right into your bank account. It could be taxed, but we’ll discuss that later.
An IRA or 401(K) that is inherited gives options depending on if you were the spouse of the deceased. If you are, you can simply convert the retirement account into your name, or take a lump sum payout. If it’s a Roth IRA, as long as the account has been open for 5 years, you can withdraw the money without being subjected to income taxes.
Non-spouse beneficiaries have a few options. It’s important to know that, as a non-spouse beneficiary, you cannot roll over the IRA into your own IRA. You can, however, take distributions without the normal penalty for early withdrawals. Not all IRAs come with the following options, but there are generally four options available:
- Cashing out the entire IRA in 5 years, where the withdrawals will be taxed as income in the year(s) withdrawn;
- Withdraw the required minimum distributions over your own life expectancy, which is a great option if you are much younger than the original account holder;
- Withdraw the required minimum distributions over the oldest beneficiary’s life expectancy;
- Cash it out immediately and take the hit to your income taxes
If you don’t take action by Dec. 31 of the next year, following the account owner’s death, then you must take the first option by default.
How Does a Trust Fund Work?
A trust fund is essentially money managed by a trustee that isn’t you, but it is your money. Usually, this trustee is a financial planner, banker, lawyer, or another family member. This can help avoid estate taxes.
Trust funds generally have stipulations, such as a monthly payout, using the money for something specific such as education, or paying out when you are a specific age.
Creating your own trust fund is fairly easy. The funds, real estate, stocks, or anything of value, are deposited in the trust. If it’s irrevocable, the contents of the trust are no longer yours, and are managed by the trustee – the bank, lawyer, etc., you put in charge. If it’s a living trust, and the conditions are met, you can still be alive when the money is dispersed.
The main downside to creating a trust over simply leaving cash in a will is the cost. A will is fairly cheap to create; a trust will likely be a few thousand dollars. This is due to needing a trust attorney, and the trustee will have to pay taxes. However, if you can afford the fees, this is a good way of ensuring your money is spent how you want. There’s also a matter of taxes.
State Inheritance Taxes
Bad news first: State inheritance taxes must be paid, by you, once you receive the assets.
The good news is that only a few states have inheritance taxes. Those states are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. If the decedent lived in those states, you will likely have to pay taxes — but they will also likely be taken out before you see the money.
State and Federal Estate Taxes
Estates will have to pay estate taxes, different from inheritance taxes, before any of the assets are distributed to heirs. That means you don’t have to worry about it, as it will be taken out of whatever money you are left before you take possession of it.
Better news: The federal estate tax exemption for gifts for 2018 continued an upward trend, at $5.6 million from 2017’s $5.49 million and 2016’s $5.45 million. If the entire estate you are inheriting is less than that number, you don’t have to pay a federal estate tax.
There are state estate taxes in Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Tennessee, Vermont, and Washington, but, like state inheritance taxes, they only apply if the decedent lived in one of those states. Each state has a different tax exemption value; be sure to check with tax professional.
State and Federal Income Taxes
More good news: Inheritance is not usually considered income. Real estate, retirement accounts, and stocks may be subject to income taxes, however, as noted above for retirement withdrawals. The year you sell the stocks or real estate may incur capital gains taxes. This is based on the value of what you sold the stocks or real estate for, compared to what it was worth when you received the assets.
Should I Invest?
This question is twofold. First, you should definitely use inheritance money for investments if possible, after paying down loans. Be smart about the investments, and you might make a profit. If the inheritance includes retirement accounts, especially Roth IRAs or 401(K)s, and you don’t have an immediate need for the money, it is wise to keep investing, especially if the accounts were profitable. With Roth accounts, the money is put in after being taxed, so withdrawing from an account that is older than 5 years incurs no penalties.
But the second part of the question is whether you should invest in a trust fund. That is, putting stocks or retirement accounts into the trust. If, for example, you have a retirement account, but know you will not live to withdraw it due to illness, putting the account into a trust will enable it to still accrue value thanks to compounding interest, and thus provide your heirs with more money than you actually deposited. The same goes for stocks.
If you are healthy, there’s still a good reason for investing in a trust fund: taxes. High-net-worth individuals can put some of their assets in a trust fund where it will no longer be considered part of their estate, as it now falls under the trust’s estate. In that way, money made through these assets is no longer counted as income, and can put you in a lower tax bracket.
If you have received an inheritance, or are looking into leaving one for your heirs, it’s important to know your options. Be sure to talk to financial advisors and probate attorneys to understand which option is right for you, and how to limit what taxes you will need to pay.
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