What to Do With Inheritance Money

Receiving an inheritance can be confusing, and depending on the size and scope of the estate and your relationship to the deceased party there can be a huge number of questions up in the air as the estate is settled. By planning ahead, you can set yourself up for success and avoid some of the most common pitfalls associated with inheriting cash and other assets.

Key Takeaways

• An inheritance can be in the form of cash or other assets like real estate or investments.
• Most inheritances are not taxed, but particularly large estates are sometimes subject to estate taxes, inheritance taxes or both.
• How you invest your inheritance—or if you should invest it at all—is largely dependent on your current financial situation, outstanding debts, and long-term financial goals.

What is an Inheritance?

When a person passes, their assets are passed along to their beneficiaries as outlined in their will, living trust or other estate planning documents. These assets can take many forms, and there is a wide variety of ways they can be distributed.

Some of the most commonly inherited asset types include:

• Cash
• Real estate
• Personal property
• Retirement accounts
• Investment accounts

Does Inheritance Get Taxed?

Inheritances are rarely taxed, and when they are, it depends on the size of the inheritance and the state in which the deceased party maintained their residence.

The federal government assesses an estate tax on inherited assets valued at more than $15 million for individuals, with assets exceeding this amount taxed between 18 percent and 40 percent. Surviving spouses are exempt from this tax, meaning there is no maximum size limit for estates being transferred to a spouse under federal guidelines.

There are some other situations in which an inheritance may be subject to taxation, though, and in these less common cases the tax burden must typically be settled before the remaining inheritance can be distributed to the beneficiaries.

States with Estate and Inheritance Tax

There are two types of taxes that are levied at the state level on inherited assets—estate taxes, which are paid by the estate before assets are distributed, and inheritance taxes, which are paid by the beneficiary as soon as they receive the assets.

There are currently 16 states with either an estate or an inheritance tax, including one state that levies both. There is also a local estate tax levied in the District of Columbia.

• Connecticut levies an estate tax on estates exceeding $13.99 million.

• Hawaii levies an estate tax on estates exceeding $5.49 million.

• Illinois levies an estate tax on estates exceeding $4 million.

• Kentucky levies an inheritance tax based on the beneficiary’s relationship to the decedent ranging from 0 percent for close family up to a maximum of 16 percent.

• Maine levies an estate tax on estates exceeding $7 million.

• Maryland levies an estate tax on estates exceeding $5 million as well as an inheritance tax of up to 10 percent.

• Massachussetts levies an estate tax on estates exceeding $2 million.

• Minnesota levies an estate tax on estates exceeding $3 million.

• Nebraska levies an inheritance tax based on the beneficiary’s relationship to the decedent ranging from 0 percent for close family up to a maximum of 15 percent.

• New Jersey levies an inheritance tax based on the beneficiary’s relationship to the decedent ranging from 0 percent for close family up to a maximum of 16 percent.

• New York levies an estate tax on estates exceeding $7 million.

• Oregon levies an estate tax on estates exceeding $1 million.

• Pennsylvania levies an inheritance tax based on the beneficiary’s relationship to the decedent ranging from 0 percent for close family up to a maximum of 15 percent.

• Rhode Island levies an estate tax on estates exceeding $1.8 million.

• Vermont levies an estate tax on estates exceeding $5 million.

• Washington levies an estate tax on estates exceeding $3 million.

• The District of Columbia levies an estate tax on estates exceeding $4.8 million.

Taxes on Inherited Retirement Accounts

Certain types of retirement accounts are also subject to taxes when the owner of the account dies. Two of the most common types of retirement plans—Individual Retirement Accounts (IRAs) and Roth IRAs—handle taxation very differently.

IRAs

An IRA is a type of retirement account that allows investors to put money into the account before income taxes are paid on the assets placed in the account, allowing a larger contribution to the account on the front end. When the money is withdrawn, income taxes are paid on the money withdrawn from the account.

One common pitfall of an IRA is the early withdrawal penalty, which assesses an additional 10 percent fee on any funds withdrawn before the owner is aged 59½. This early withdrawal penalty is not assessed on inherited IRAs, and in some cases the account must be completely emptied before the beneficiary reaches this age.

In cases where a spouse inherits an IRA, the account can usually be rolled into their own retirement accounts and kept until they reach the required age for withdrawals and required minimum distributions. Other beneficiaries are usually required to withdraw the funds within 10 years of inheriting them.

Regardless of when the funds are withdrawn, they are subject to the same income tax requirements as any other IRA withdrawal and are treated as income by the IRS for all intents and purposes.

Roth IRAs

Unlike a traditional IRA, Roth IRAs require investors to pay taxes on income before it can be placed in the account. The assets in the Roth IRA are then allowed to grow tax-free until they are withdrawn after retirement.

As long as the original owner of the Roth IRA held the account for at least five years before their death, beneficiaries inheriting a Roth IRA typically do not have to pay income tax on withdrawals from these types of accounts and can treat the account just like a Roth IRA of their own.

What to Do With an Inheritance

Inheriting money or other assets can be overwhelming, especially in cases where an estate is particularly large or a death is unexpected. Despite the emotional turmoil you might be experiencing at the time the assets are transferred to you, it’s important to keep a level head and make smart decisions to ensure the assets will work to your advantage and not incur a massive tax bill.

Wait

Making decisions quickly with your inheritance is an easy way to wind up in a less-than-favorable situation. The best thing you can do in many cases when receiving an inheritance is to take a beat and create a plan. Put assets into short-term, safe accounts when it makes sense and talk to your financial advisor about the best next steps. While it can be tempting to spend a big chunk of cash as soon as you receive it, you may be setting yourself up for big problems come tax time.

Pay Off Debt

Before you start investing your inheritance, it’s usually a good idea to pay off outstanding high-interest debt and create a stronger financial baseline for your future. By clearing out things like credit card debt and personal loans, you can focus the remainder of your inheritance and your existing income into investment strategies that work best for you.

Build a Contingency Fund

You never know when an unexpected mishap might occur, and an inheritance can help safeguard against unexpected expenses or loss of income. Consider setting some inheritance money aside for a rainy day before deciding what to do with the rest.

Invest For Long-Term Gains

A sudden windfall like an inheritance can be tempting, especially for individuals without a ton of disposable income. The urge to splurge can be hard to dismiss, but using your inheritance as a vehicle for future financial freedom will almost always yield better outcomes than blowing through the money as soon as it arrives. Even a modest inheritance can turn into a major financial boon with enough time.

Disclaiming an Inheritance

In certain cases, an inheritance does not prove beneficial to its recipient. When an individual determines they do not want to receive an inheritance, they must submit a legal document known as a qualified disclaimer within nine months of the asset owner’s death.

There are numerous reasons why a person might want to disclaim an inheritance.

• Disclaiming an inheritance can allow it to pass on to a child or other beneficiary who would benefit more from receiving the assets.
• A modestly large inheritance could impact an individual’s income level enough to make them no longer qualify for certain benefits like Medicaid.
• If an individual is deeply in debt, creditors may seize inherited assets that could otherwise be passed along to other beneficiaries.
• Some property is in disrepair or simply requires more maintenance than a beneficiary can afford. In these cases, the assets prove to be more of a burden than a benefit to their recipient.

Bottom Line

Receiving an inheritance can be a tricky process, both financially and emotionally. If you prepare for the most common situations in advance, though, it’s possible to make the right choices for you and your individual situation and leverage inherited assets to build wealth for the future.

If you have recently received an inheritance or are expecting to in the future, Horizons Wealth Management can help you navigate this financial change in your life.

Receiving an Inheritance FAQ