Estate Planning


Heirs Should Treat Windfall With Special Care

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The death of a parent is a life changer. On top of the emotional turmoil that comes with such a major loss, there may well be an inheritance to deal with. Whether it's large or small, such a windfall offers numerous opportunities for adult children, such as paying down debt, financing a retirement or pursuing new interests.

See Also: Estate Planning Special Report

Two-thirds of baby boomers are likely to receive inheritances totaling upward of $8 trillion, according to Boston College's Center for Retirement Research. But it's easy for new heirs to make a mess of their parents' financial legacy. The laws governing inherited retirement plans, investment portfolios and homes are complex. But with care, you can avoid the pitfalls.

The first step: Hold off on big money decisions. You'll need to meet some legal deadlines, and perhaps you can visit a financial planner to sketch out possible future scenarios. But if you act precipitously, you can end up with an inflated tax bill or a huge vacation home you can't afford to maintain. Don't quit your job, start a new business, buy a summer home or dole out money to charity, says Joan Sharp, a certified financial planner and founder of Life Strategies, in New Castle, Del. "You need to stop and take a breath, and don't jump into making big decisions," she says. "People who are going through a transition are off their game, especially when it comes to money."

You should, however, take some initial measures to protect your newfound wealth. You may need to buy personal liability insurance or expand the coverage you already have. Such coverage, also known as umbrella insurance, protects you if someone is injured as a result of your negligence—for example, if someone falls on your property. Umbrella coverage typically exceeds the limits of auto and homeowners insurance. "If you have a lot of assets, you become more of a target," says Robert Pagliarini, president of Pacifica Wealth Advisors, in Mission Viejo, Cal.

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Place any cash you receive into federally insured money-market accounts until you decide what you want to do with it. Divide the money among several banks if you inherit more than $250,000, which is the most that the Federal Deposit Insurance Corp. will cover for a single account at one bank.

You could place some of the cash into a three- or six-month certificate of deposit—the early-withdrawal penalty will help you resist the temptation to spend immediately. "It's not easy for me to see $1 million sitting in a cash account," Sharp says. "But until you put a plan together, it is the wiser thing to do."

If you receive proceeds from a life insurance policy, decline an entreaty by the insurance company or agent to sell you a new policy or an annuity. Also, the insurer may offer to place your money in its own money-market fund and send you a book of "drafts," which are similar to checks. Turn down this "retained account" option—some retailers don't accept drafts, and the money in the account is not insured.

Also be sure to hold inherited assets in your name only. Depending on the state, keeping the money in an account under your own name will protect it from being divided equally in the event of a divorce. Even if a divorce is unlikely, consider what could happen if the assets are owned jointly and you die first. If your spouse remarries, there is the chance the inheritance will pass on to the new spouse or children from an earlier marriage.

It's also important to put together a team of advisers. You can use your parent's estate-planning lawyer or use your own. Consider hiring a fee-only certified financial planner to help you chart some goals for your sudden wealth. For larger inheritances, seek the help of a certified public accountant or a tax lawyer. "If a boomer is getting a windfall, it's worth a few dollars to go to a professional," says Martin Shenkman, an estate-planning lawyer in Paramus, N.J.

The estate's executor will carry out many of the tasks of settling the estate. Shenkman notes that a parent's lawyer represents the executor, not the beneficiaries. "If you don't like what the executor is doing, hire your own lawyer," he says. In most cases, he says, the heirs and executor "are on the same page." And typically at least one beneficiary acts as the executor.

Be careful with retirement accounts. It's likely that a good chunk of your inheritance will be a traditional IRA or Roth IRA. IRA inheritance rules are complex, and you can jeopardize the tax shelter if you don't carefully follow them. You can allow your money to grow in a tax shelter for your lifetime, taking only required minimum distributions each year.

While a widow or widower can roll an inherited IRA into his or her own IRA, nonspouse beneficiaries cannot. "Make sure you title the IRA correctly," Shenkman says. "Otherwise, you can trigger income taxes on all of it."

A nonspouse heir must set up an "inherited IRA," and the name of the parent, or perhaps aunt or uncle, must remain on the account. Use language like this in the title: "Inherited IRA of John Sr. for the benefit of John Jr." If you mistakenly roll the money into your own IRA, you will pay income tax on the entire amount.

Once you set up the new account, warn the custodian of your parent's IRA not to liquidate the account and write you a check. "If you take a check and cash it out, you can't put the money into an IRA," says Diane Pearson, a certified financial planner at Legend Financial Advisors, in Pittsburgh, Pa. "It becomes 100% taxable." Instead, ask the custodian to conduct a trustee-to-trustee transfer to your new account. (The 60-day rollover rule that generally applies to IRAs does not apply to inherited accounts.)

You must take required minimum distributions from inherited traditional IRAs and Roth IRAs. You will pay income tax on withdrawals from a traditional IRA but not from a Roth. (You will not owe tax on any after-tax contributions your parent made to the traditional IRA; for the Roth, you may pay tax on the earnings in certain circumstances.) Generally, you have until December 31 of the year following your parent's death to take your first RMD, which will be based on your own life expectancy. If you fail to take a distribution by then, you must liquidate the entire account within five years after the year of the account holder's death. Also, if your parent died after age 70 1/2 and owned a traditional IRA, you will need to take his or her RMD before you move the remaining money to an inherited IRA.

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