This week, join us on Friends Talk Financial Planning as we talk about some key considerations when inheriting money or other assets.
We first discuss considerations when inheriting money, particularly from retirement accounts. When inheriting 401(k)s or IRAs, distributions are taxable, and it's recommended to spread withdrawals over 10 years to avoid large tax hits, as taking a lump sum could push you into a higher tax bracket. In contrast, Roth IRAs and Roth 401(k)s offer tax-free distributions, making them the most advantageous to inherit, and it’s also advised to take these distributions last for continued tax-free growth. Taxable accounts, such as stocks or real estate, benefit from a “step-up in basis,” meaning the asset's value is set at the time of the original owner’s death, which reduces capital gains taxes when sold. However, any growth after inheritance is taxable if sold later.
We recommend a strategy for using inherited funds in the following order: taxable accounts first (due to taxes on future growth), followed by Roth accounts, and lastly IRAs/401(k)s. Finally, it is important to keep inherited assets separate from marital property to preserve their individual status for tax purposes. If you have questions or want individual guidance with an inheritance, consult a tax or financial advisor to minimize unnecessary tax burdens and maximize your inherited money.
Resources:
- Alliance of Comprehensive Planners: https://www.acplanners.org
- John's firm website: https://www.trinfin.com
-Find us on Facebook: www.facebook.com/friendstalkfinancialplanning
TRANSCRIPT:
Bridget: Hey, John, I get calls pretty often with people asking, “Hey, I inherited money. What do I do?” In this episode of Friends Talk Financial Planning, we're going to talk about what we tell people when they tell us they inherited money. Hi, I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. And before we jump into what to do when you inherit money, I want to just remind everybody to hit that subscribe button. That helps other people find this information on YouTube and helps us grow our channel. And with that, I’m looking forward to jumping in. When you said what to do, the first thing I thought was, “Have a great, big party.” It sounds like fun, right? I get all this money, here's what we can do.
Bridget: Book the Concorde, right?
John: Yeah. But when you inherit, a lot of times we'll talk about, “Hey, money is money. Where's the best place to take it from?” This is true, but especially when you inherit money, there're three flavors of what things you inherit. We've got IRA based things, 401(K)s, 403(b)s, those sorts of things. And then we've got Roth IRAs and Roth 401(k)s, and then we've got stuff that's not in either of those two accounts, that's just regular taxable stuff. So I think about those three buckets, and there're different ways to talk about this, but I think the most complicated one is the regular IRA stuff. I inherited a 401(k) from my mom. What do you say? What are the first steps you walk people through?
Bridget: Well, I tell people if they inherit an IRA or a 401(k) or anything that has not been taxed before, then it hasn't been taxed before, and therefore you're going to be including it in your taxes when you take the money, so you want to be smart about it. And there're going to be some requirements, and you want to look up those requirements, whatever they are. There're going to be requirements, and they've been changing a lot. And even then, there's a lot of pushback, so what are these requirements? You either want to look it up or talk to your tax advisor, but you're going to need to take some money out periodically.
The other thing is that in the vast majority of cases, the most advantageous thing for you to do is to break it up over that time period. You have to generally take things out in 10 years. Just take it out equally over the 10 years. That's what I generally recommend for people. And if you want to pay off your house or something, okay, great, do it over 10 years, and don't try to do it all at once, because it's going to hit your taxes. And so, let's say you have $100,000 inheritance. Increasing your income by $10,000 a year probably isn't going to affect your taxes that much. But if you increase it by $100,000 a year, all of a sudden you look like a rich person for a year.
John: Right.
Bridget: And that's not because you're booking the Concorde. It's just because you got this one off. Depending on the amounts, if it's $10,000, it's not going to make that big of a difference, but if it's $100,000, it's going to impact your taxes and who needs that?
John: Yeah. And it feels different. When I save money in my 401(k) or other places, I don't look at that as accessible money. And suddenly I get an inheritance, and I go, “Oh, look, there's money.” Paying off a house, paying off credit card, there're things I can do with this, but I got to step back and go, “Hang on a second. What are the tax consequences? Oh, yeah, this 401(k) stuff all adds to taxable income. I got to be really thoughtful about how I do that, look up the rules and then kind of figure out what makes sense for me. It's not free money that I can just write a check on because the tax bill is going to come due at some point in time on that.”
Bridget: Absolutely. And so, then the next flavor that we're talking about is Roth IRAs and Roth 401(k)s. Now those are tax free. When you take the money out, you're not going to have to pay tax on those, which is great. And you will have to take those out over the course of 10 years, generally. In that case, that would be the last money that I take out, because you want it to be able to grow tax free again due to the fact that it's all going to be tax free when you take the money out. What are your thoughts?
John: “Hey, I inherited an IRA. What do I do?” Well, it kind of depends. All the language sounds the same but on the one hand it's sort of a tax time bomb. I got to think about the taxes. On the other hand, there're no taxes. And that sounds awesome. But I agree with you saying, “How much more can I compound this tax-free growth in the Roth?” So it's tax free but at the same time I still have to think about it and make a smart decision for my particular situation.
Bridget: Yeah. So if you're not familiar with Roths, all those earnings are going to be tax free. So it can earn money for 9 or 10 years or however long you keep it in there. And again, when you take it out, that's not going to be taxable. Our third flavor is what we in the industry call a taxable account. So that's basically the process of elimination. It's not one of the other two.
John: Right.
Bridget: And so usually you get these if there’s a bank account that you inherit, or a lot of people save money the old fashioned way. They just have stocks at a custodian, like a stock account at Schwab. But you have to be careful because it could be an IRA or 401(k). So you got to look at the title, you have to look at the document and see how it's titled. But a lot of people just have stocks etc. Also, if you inherit real estate, I'm going to assume that it gets sold eventually, or even if it's not sold, it's of this type, so the tax rules around this apply. And the basic rules are that whatever it was worth on the date of death is what it's worth to you.
And more technical than you ever want to hear from me, that's what's going to be called the basis. So you get what's called a step up in basis because it goes from whatever the other person bought to you. And so, this could be Apple stock that they bought for $1 and now you got it and it's $1,000. All of that capital gain is tax free, which is great. And your basis is whatever the value of it is when you inherited it. And that is true for stocks, but it's also true for real estate. If you inherit a house, whatever the house is worth when you inherit it is what is going to matter when you go ahead and sell it or if you go ahead and sell it. Do you have anything to add there?
John: There are just a couple of things I want to pull out. I thought it was a really, really key point and something that we maybe take for granted. But when somebody says, “Hey, I inherited some money.” “What'd you inherit?” “Oh, just some stocks and mutual funds.” Well, it depends. Stocks and mutual funds can live inside of an IRA. Hey, there are some different tax consequences. They can live inside of a Roth IRA. I can have stocks and mutual funds inside of those. I can have it in this taxable brokerage account. Just knowing what the underlying investment is doesn't really tell you the tax consequences, so you have to dig just a little bit deeper.
And I think you said, “What does the title on the account say? What does it say when it shows up on the statement?” That tells you something really important, because you can have those same things inside three very different accounts from a tax standpoint. I thought that was a really great point you brought up. And then the other thing is just about those three different categories and how to think about them. This basis stuff is complicated, but you kind of got to know, hey, it's called that step up in basis. You got to know that it exists so you can talk with your tax and investment people about it.
But then if you leave money in that regular taxable account—stocks, mutual funds, bonds, whatever—if that continues to grow from after you inherit it, then when you sell it, there're going to be some taxes that you have to pay when you sell on the future growth. And you don't need to know the details or understand exactly, other than that for taxable money, future growth has some tax consequences. For Roth IRA money, future growth has no tax consequences. IRA money has tax consequences, no matter what.
Bridget: Right.
John: So if somebody's got some credit card debt or wants to pay off their house, if I just inherited an IRA or a 401(k), I got to think about those rules we just described. But what happens when I inherited an IRA from my dad, and I inherited a Roth IRA and some regular taxable money. Now I've got some different choices. I got to think about all those things and then make the best decision as far as where to spend money to pay off my credit card or pay for my son's college or that sort of thing.
And oftentimes that taxable money, real estate that went up and we sold, or a mutual fund portfolio that's not inside of an IRA is the best place to start from a spending standpoint. Again, you got to look at all these things, but that's one of those things we should look at when we need to spend money on things because of the way that it works from a tax standpoint.
Bridget: Right. So we're saying, if you had all three, and you had some immediate spending that you wanted to do, you'd probably use a taxable account first, the Roth account second, and then try to delay taking the IRA account so that it's equal over time. Although if you had big credit card bills at a high interest rate, it might be worth it.
John: Right. And again, you just have to balance this. I think that's maybe one of the big takeaways. You have to balance these three different things. There's no one answer. For example, we've got to spread out these distributions on an IRA. If I decide, hey, I'm going to take out $10,000 a year from this IRA, well, maybe that's a place to start with paying off some of the debt. And then I go, “Geez, I want to pay my whole mortgage off.”
Well maybe the brokerage account, that taxable money, is the next place. If I want to take out $100,000, geez, maybe I don't want to take it out my IRA, because then I look rich to the government. I would take it out of the brokerage account and then it's the same amount of money, but I look less rich from a tax standpoint. To know that these different things exist and then to be intentional about making those decisions, I think is a really great takeaway.
Bridget: Yeah. And we want to just mention, another thing to be cognizant of if you inherit money is that money gets inherited on an individual basis. And so if you are part of a couple and you're married, it's not part of marital property and you want to keep it individual.
John: Yeah, that’s a great point.
Bridget: That doesn't mean don’t share it with the other person, don't give them any money or anything like that, but it's in your account. And don't take marital money and put it in there.
John: Yeah, that's a great thing. And that’s what we recommend. I've done it myself. When we inherit money, we keep it in a separate account, just because you can't undo it after the fact. That's great.
Bridget: So you want to be careful about that.
John: Yeah. Great.
Bridget: Let’s wrap up. I'm Bridget Sullivan Mermel. I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. Both Bridget and I are taking on new clients. We'd love to hear from you. But if you'd like to find an advisor in your local area, both Bridget and I are members of the Alliance of Comprehensive Planners. And you can check out acplanners.org to find somebody who's close to you.
Bridget: And don't forget to subscribe.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.
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