If you’ve ever read an article about what someone dies with a financial windfall, it’s probably been about a truly life-changing amount of money. A recent article from CNBC, “Receiving an inheritance? Here’s how experts say to handle any windfall,” says the average American inheritance across all age groups and incomes between 2001 and 2019 was just over $12,000. These numbers are from the University of Pennsylvania’s analysis of data from the Federal Reserve’s Survey of Consumer Finances. Whether it is a large sum or more modest, there are wise strategies to manage an inheritance.
The number is skewed down by the vast majority of Americans who don’t receive any inheritance. Looking just at those who did receive an inheritance, the average amount was about $184,000—a healthy amount, but not enough to retire.
You’ll likely fold that money into your current financial plan if you receive an inheritance. Inheritances usually come in three different forms: cash, real estate and investments.
A cash investment is the easiest to handle if you’re not receiving an enormous amount. In 2023, you won’t owe any federal taxes on inherited cash up to $12.92 million. However, depending on where you live, there may be state estate or state inheritance taxes.
Unless you grew up in a palace, it’s not likely you’ll need to deal with the insurance tax limit on a real estate inheritance. With the rule known as “step-up in basis,” you likely won’t owe any tax on property you inherit—not initially, anyway.
The value of an inherited home resets when the owners die. If your parents paid $100,000 for a house and gave it to you when its fair market value is $500,000, and you sold it the next day, you’d owe tax on the $400,000 gain. However, if they die and leave the house to you, the value of the house, known as your basis, is the fair market value of the house—$500,000. If you sold it for this amount, as far as the IRS is concerned, you would not realize a gain. However, there are time limits. There’s a step-up in basis at the time of death, but the estate settlement process can drag on for six or twelve months.
A house can’t be divided up as neatly as cash. If you have siblings, one may want to sell the home for cash. Another might want to rent it out. Another might want to move in.
Get the property appraised as soon as possible and get at least two appraisals. This will make life easier for everyone. If one sibling wants to buy the other’s share of the home, you’ll all know exactly what the shares will be. It also gives you the number when determining when or if to sell it.
Remember, real estate requires maintenance, so until the house is sold, there is an obligation to pay the mortgage, property taxes and upkeep.
Like real estate, any investments inherited in taxable accounts come with a step-up in basis. If your parents paid $10 for Apple stock, you’re inheriting it at its current market value. You can sell it at its basis, and it’s cash. If you decide not to sell it and hang onto the investments, the rules apply as if you bought the stocks at market value, and you’ll owe tax on any gains realized.
The rules are tricky when it comes to inheriting retirement accounts. Plans funded with pre-tax dollars, like 401(k)s and traditional IRAs, are taxable when money comes out for the owners. For heirs, the IRS now gives a ten-year window to empty some of these accounts. If you’re in your peak earning years when you inherit, this can significantly affect your income tax liability.
It is wise of heirs and their benefactors to sit down with an estate planning attorney to map out the best strategies to manage an inheritance. Both benefactors and heirs would benefit in terms of taxes and a smooth transition of assets passing from one generation to the next. It’s something to consider. If you would like to learn more about managing an inheritance, please visit our previous posts.
Reference: CNBC (Oct. 16, 2023) “Receiving an inheritance? Here’s how experts say to handle any windfall”
Photo by Polina Zimmerman
