Smart Ways to Manage an Inheritance

How you manage an inheritance can change your life. We’ve all heard stories about individuals who passed away quietly after a life of frugality, keeping their estate plan a secret and leaving a fortune to their unsuspecting heirs. Or, alas, occasionally bequeathing their riches to a beloved pet.

The reality is a lot less riveting. Only one of every ten Black families and about one-third of white families receive any inheritance at all, and more than half of all inheritances total less than $50,000, according to a 2023 study by the Federal Reserve Bank of Boston.

Before you try to manage an inheritance

Before you make any decisions about your inheritance, ensure you understand what you will be getting. Many estate plans contain a smorgasbord of items, including real estate, investments, cash, retirement savings accounts and life insurance plans. It could take months to track down these assets and divide them among the estate’s heirs, and you could incur significant legal fees — particularly if the estate was large or your relative died without a will. 

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There are also different rules for different heirs: Spouses, for example, enjoy some tax breaks and exemptions that aren’t available for adult children or other heirs.

For example, Brian Lee of Tacoma, Wash., got a crash course in estate law after his late father’s brother and sister died almost within a year of each other, in late 2015 and 2017. Neither of his father’s siblings had children when they died, so their estates were divided among their nieces, nephews and other surviving relatives. 

Lee ended up with a six-figure inheritance, but because his uncle died without a will, settling the estate took months and cost thousands of dollars in legal fees. Lee’s aunt had a will, with Lee as the executor, which made “all the difference in the world in terms of the process,” Lee says.

Also, in addition to federal taxes, beneficiaries should be aware of any state inheritance taxes. The regulations and exemptions at the state level can vary a great deal and could impact your inheritance.

Here's what you need to know in order to handle an inheritance like a pro.

What you’ll owe in taxes on your inheritance

Depending on the assets you inherit, you may, or may not, have to pay taxes. Typically, heirs won’t pay the federal estate tax unless the value of the estate exceeds the exemption amount.  So, unless your parents were fabulously wealthy, you won’t have to worry about federal estate taxes, but that doesn’t mean Uncle Sam has no interest in your inheritance. 

For anyone who passes away in 2024, the exemption amount is $13.61 million (up from $12.92 million in 2023). For married couples, that number jumps to 27.22 million because each spouse can take advantage of the exemption. These generous exemptions sunset after 2025, so be sure to plan for 2026 taxes if you expect to inherit then.

Stocks

If you inherited stocks, mutual funds or other investments in a taxable account, you’ll be able to take advantage of a generous tax break known as a step-up in basis. The cost basis for taxable assets, such as stocks and mutual funds, is “stepped up” to the investment’s value on the day of the original owner’s death. 

For example, if your father paid $75 for shares of stock that were worth $575 on the day he died, your basis would be $575. You won’t owe any taxes if you sell the stocks immediately, but if you hold on to the shares, you’ll owe taxes (or be eligible to claim a loss) on the difference between $575 and the sale price.

It’s a good idea to notify the investment account custodian of the date of death to ensure that you get the step-up, said Annette Clearwaters, a certified financial planner in Mount Kisco, N.Y.

Because of this favorable tax treatment, a taxable-account inheritance could be a good source of cash for a short-term goal, such as paying off high-interest debt or making a down payment on a house, said Jayson Owens, a certified financial planner, with offices in Anchorage, Alaska and Tacoma, Washington. If you’d rather keep the money invested, review your inherited investments to see whether they are appropriate for your portfolio. For example, you could sell individual stocks and invest the money in a diversified mutual fund without triggering a big tax bill.

Retirement accounts 

If you inherit a tax-deferred retirement plan, such as a traditional IRA, you’ll have to pay taxes on the money. Spouses can roll the money into their own IRAs and postpone distributions — and taxes — until they’re 73.  The rules and timelines differ depending on your relationship to the deceased. For example, if you inherited a retirement plan from a parent or sibling, you must follow different guidelines. 

The rules for inherited retirement plans are complicated and in flux, so review the tax requirements carefully.

If you inherit a traditional IRA

If the deceased was not your spouse, then the ten-year rule applies. This means you must distribute funds within ten years after the original account holder's death. There are some exceptions in the case of minor children or disabled heirs, for example. Check these exceptions in case you might qualify.

Heirs will also pay different tax amounts depending on whether the original account owner died before or after they had to take annual distributions, known as required minimum distributions (RMDs). 

In 2020, the IRS announced rules that would penalize heirs for failing to take proper distributions from inherited IRAs. The roll-out of these rules caused such confusion over inherited IRA rules that the IRS clarified the process in the SECURE 2.0 Act. This Act lowered penalties for failing to take IRA distributions from 50% to 25%. It also made changes to some of the age requirements. Given the complexity of these changes, it's best to consult a tax professional before you designate how you will receive RMDs. 

If you inherit a Roth IRA

If you were fortunate enough to inherit a Roth IRA, you’ll still be required to deplete the account in 10 years, but the withdrawals will be tax-free. 

Get some help

If you inherit a traditional IRA or 401(k), you may want to consult with a financial planner or tax professional to determine the best time within the 10-year window to take taxable withdrawals. For example, postponing withdrawals until after you stop working may make sense if you're close to retirement since your overall taxable income will probably decline.

Real estate

When you inherit a relative’s home (or other real estate), the value of the property will also be stepped up to its value on the date of the owner’s death. That can result in a large lump sum if the home is in a part of the country that has seen real estate prices skyrocket. 

For instance, if you inherit a property that was purchased for $150,000 initially, but is now worth $300,000 at the time you inherit it, the basis is stepped up to $300,000. You not only benefit from the immediate break, but this step up can also significantly reduce any capital gains taxes if you sell the property later. 

Selling a home, however, is considerably more complex than unloading stocks. You’ll need to maintain the home, along with paying the mortgage, taxes, insurance and utilities, until it’s sold.

Life insurance

Inheritance from a life insurance policy isn’t generally taxable as income. The money may be included in your estate for purposes of determining whether you must pay federal or state estate taxes. However, when a death benefit is paid out as a lump sum rather than in installments, the interest earned on the death benefit is taxable. 

Also, if you transfer your insurance policy over to someone, a gift tax may be applied and withdrawing money from the cash value of a life insurance policy could also spark income taxes.

Spending your windfall

Even a small inheritance can represent more money than you’ve ever received at one time. Go ahead and treat yourself to a modest splurge — a special vacation, for example — but avoid making costly changes in your lifestyle.

Brian Lee used his inheritance to pay off his wife’s student loans and a small credit card debt; the rest went into retirement savings. Lee says he wanted to honor the legacy of his uncle, a dedicated investor who worked for IBM in the custodial department for 30 years. Lee’s uncle spent most of his life in the same small house in Austin, Texas, and drove a 1967 Ford truck, but he was a wealthy man, with an estate valued at more than $3 million when he died. “There’s no way I would blow money someone spent a lifetime saving,” Lee says.

However, many people overestimate how long their newfound wealth will last. For this reason, consider stashing your inheritance in a money market account or CD account for six months to a year. You'll earn interest on your cash, and your money will be safe while you assemble a team of professionals, which typically should include a fee-only planner, a tax professional and an attorney.

Your team can help you look for ways to fortify your finances. Paying off credit cards and student loans will relieve you of high-interest debt and free up cash for other purposes. If you haven’t saved enough to cover several months’ worth of expenses, use your windfall to beef up your emergency fund. 

Once you’ve got that covered, consider using your inheritance to increase retirement savings. Finally, if you don’t have an estate plan of your own, use some of the money to create one, including powers of attorney, health care directives, a will and, if necessary, a living trust. Your own heirs will thank you.

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• IRS Ends Inherited IRA Confusion: Annual RMDs Required for Many
• Six of the Best Assets to Inherit
• 10 Things You Should Know About Estate Planning