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Baby Boomers are the wealthiest generation in American history. Over the next 30 years, an estimated $30 trillion will be passed down to Gen X’ers and Millennials. If you’re expecting an inheritance, you can make preparations now.

1. Know the tax rules.

Most are confused about what taxes they will owe when it comes to an inheritance. There are two types of taxes that only affect a small number of people: inheritance tax and state tax.

  • Inheritance tax, which is the responsibility of those receiving the money, is levied by a handful of states, and Arizona isn’t one of them. 
  • Estate tax is a federal tax, although some states also impose an estate tax. This is to be levied against the estate of the deceased before the assets are distributed to the beneficiaries. Fortunately, the current federal estate tax exemption is historically high—$11.58 million per individual. If you are the beneficiary of an estate that’s under $11.58 million, estate tax will not apply to you.  If the estate is over that amount, the estate tax will have to be satisfied before you receive your inheritance.

Other tax considerations have to do with the types of assets being inherited.

If you are the beneficiary of a retirement account like a 401(K) or IRA, new tax rules under the SECURE Act of 2019 impact these types of accounts. As in previous years, you can open an inherited IRA for these assets. Unlike previous years, you can no longer take smaller required distributions over your lifetime. Now, you must distribute the entire account within 10 years.

Why is this a big deal? Taking distributions from inherited retirement accounts is taxable as income in the year you take the withdrawal. You are no longer allowed to “stretch” that tax bill over your lifetime. The 10-year window requires those distributions (and subsequent taxes) to be paid in a relatively short period.

Lastly, other types of assets get a favorable “step-up in basis.”  Normally, you pay a capital gains tax when you sell an asset that has appreciated. For example, if you bought a stock at $10 per share and sold it at $25 per share, you pay tax on the $15 of appreciation. However, if you inherit a stock that your loved one bought at $10 per share, you are allowed to adjust the basis of that stock to its value on the date your loved one passed away. So, if he/she passed away when the stock was valued at $25, you will only pay tax on any subsequent gains from that date.

Types of assets that are allowed a step-up in basis include:

  • Stocks
  • Mutual funds
  • Real estate
  • Businesses

2. Treat it like your regular income.

You can begin to make a plan for how to use your inheritance, even before you receive the funds. To be successful with your inheritance, it’s good to know how our brain is wired when it comes to receiving money.

Mental accounting describes a way in which we treat our money differently depending on where it came from or how we intend to use it. We mentally organize our money and use this to make financial decisions. Though it sounds like a good thing, mental accounting can result in irrational decision making.

We value money differently depending on where it came from. “Found” money tends to be placed in our mental “discretionary” account, where we are free to spend it on whatever. An inheritance, along with a tax refund, a gift, or literal money that we find on the street, are treated differently than money we earn through employment.

This is ignoring the fact that money is fungible, meaning its interchangeable, regardless of the source. If you are going to spend $100 on a nice dinner, it doesn’t matter whether the $100 you use was earned from your job, your spouse’s job, was taken from a savings account, was taken from a checking account, or was spent with the $100 bill you have in your pocket. In all these scenarios, you are still spending $100.

Mental accounting is the reason people save only half of their inheritance, while one-third end up spending it all. The challenge when receiving an inheritance is to treat it like income we receive from our job. Can you still spend some of it on a vacation? Sure. But it’s irrational to mentally account for it as a separate source that we can value differently.

3. Don’t be afraid to invest a lump sum.

You’ve decided to invest some of your inheritance. Nice work! Now, when should you invest?

Though it seems straightforward to invest it in a lump sum, the reality is people have a hard time pulling the trigger. The fear of mistiming the market is real. No one wants to start investing right before the market goes down.

As a result, it’s tempting to wait on the sidelines for the market to fall and then invest at the opportune time. After all, we think back to our own experiences of seeing market bottoms for stocks, real estate, and cryptocurrencies and thinking, “If only I would have bought then!” But timing the market is hard to do! If it was easy, everyone would be doing it. Often, you may find yourself with a bad case of FOMO if the market continues to go up.

You are left with two options: invest a lump sum or invest over a period of time (also called dollar cost averaging).  Which is a better strategy?

Studies have shown that investing a lump sum usually beats out dollar cost averaging. The market is up more than it’s down and putting more money to work earlier makes this strategy better. If the market does go down, or has more volatility, a systematic investment plan can offer better results. But we don’t know ahead of time if that will be the case.

Bottom line—don’t be afraid to invest a lump sum. Even if it’s a bad time, the market has always recovered.

4. Honor the benefactor.

What better way to honor your loved one than by making good decisions with your inheritance? Think of it this way—they spent a lifetime saving this money (so don’t just spend it all!) 

Consider giving a portion of your inheritance to a charitable cause. If you will be receiving a sizable inheritance, a donor advised fund (DAF) may be a simple solution to make one initial gift while giving you time to consider what organizations you would like to support.

A DAF simplifies charitable giving. You make a gift to the DAF and get a tax deduction. The money in the DAF can be invested and continue to grow. When you’re ready, you can make gifts out of the DAF to organizations that you would like to support. A DAF is one tool to help you make a greater impact with the funds you will be inheriting!

Passing on wealth to the next generation can be a tremendous blessing. As a beneficiary, it can be hard to plan on an inheritance. You want to honor their lifetime of hard work, so making simple preparations now can help sort through your emotions when the time comes.

Know someone who has recently received an inheritance? Share our post to help not only yourself but others be wise stewards with their money. 

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