While inheriting money, property, and other assets can bring about positive changes for your household, handling an inheritance can be difficult as you’ll almost certainly be dealing with a loss at the same time. One important piece of advice—take time to process the loss before making big lifestyle or financial choices. However, don’t wait to understand the tax implications or hire professionals to help. Then, once you’re ready, you can implement your plan for using the money.
Many People Don’t Pay Taxes on Inheritance
As the recipient, you won’t have to pay any federal income or estate taxes on an inheritance. About 55% of inheritances are less than $50,000 according to the Federal Reserve, with an additional 30% being in the $50,000 to $249,000 range.
Estate taxes can be imposed on the deceased’s estate, but that happens before you receive your portion of the inheritance. Even then, there’s an $11.2 million exclusion for federal estate taxes, and most states don’t have an estate tax at all.
The one tax you may have to pay simply for inheriting the money is a state-level inheritance tax, but that only exists in a handful of states.
While you don’t have to pay an estate tax, you may wonder about taxes involved with selling assets, such as a home, vehicle, stocks, or bonds. When assets are passed on, they receive a “stepped-up basis,” which means their cost basis becomes the asset’s market value at the time of death. As a result, you may have to pay less capital gains taxes if you sell the asset.
For example, if you inherit a parent’s house that was bought for $100,000 but worth $250,000 at the time of death, then the home’s cost basis is $250,000. If you sell for $280,000, you only pay capital gains on $30,000—the difference between your cost basis, $250,000, and the sale price of $280,000.
One special, but common, circumstance is inheriting money that’s in a tax-advantaged account, such as an IRA. In these cases, you may want to hire a tax professional as there could be significant tax consequences for how (and when) you move or withdraw the money.
You May Want to Hire Several Professionals
Hiring professionals can be particularly helpful when you receive a large inheritance, aren’t sure where to start, or beneficiaries begin to argue. A few types of professionals you may want to consider are:
- An attorney: Even when there was a will or trust, a probate, estate, or trust lawyer can help you (or the estate’s executor) navigate the process. Having legal guidance when estate planning wasn’t done can be even more important.
- A mediator: If disputes arise, hiring a mediator may be a less expensive option for coming to an agreeable decision than having each party hire their own attorney.
- A fee-only financial advisor: For advice on how to manage the money, you may want to hire a financial advisor who is a fiduciary (i.e., must put your financial interest first) and fee-only (doesn’t get commissions for selling you specific financial products). You can look for someone within an association, such as the National Association of Personal Financial Advisors (NAPFA), that requires these standards from its members.
- A tax professional: Depending on the situation, a tax professional could also be helpful. Ask about their experience with inheritances, as someone may have a CPA or be an enrolled agent (EA), but that doesn’t mean they’ve handled similar situations.
Depending on the circumstances, you could also find yourself hiring a real estate agent, property manager, or estate sale company.
Have a Plan for Saving and Spending the Money
Stories abound of people who inherit significant sums, only to be left with nothing after a few years. Even worse, there are examples of beneficiaries who purchase a new car or home but don’t have enough income to pay for ongoing expenses, such as maintenance and insurance. With or without the help of a professional, proper planning can help you avoid potential pitfalls.
As with other times when you receive a windfall gain, such as a tax refund or lottery winnings, you can take a waterfall approach—taking care of one financial responsibility until you fill up that pool and drop to the next level. Consider the following order:
- Set aside six months’ worth of living expenses as an emergency fund
- Pay off high-interest debt, such as credit card debt
- Invest in employer-sponsored retirement plans if your employer offers a match
- Save for retirement in an individual retirement account
- Pay off low-rate debts
Although building an emergency fund and paying off high-rate debts are often on top, your particular situation is going to dictate the priorities and options. Some people may also set aside a small portion of the money as “fun money” before pouring the rest into their waterfall.
You may also want to consider the wishes of the person who gifted you the money. For instance, setting aside money you receive from a parent for your child’s education fund could be especially meaningful, even if doing so might not be the most financially prudent move. Similarly, you may want to give away some of the money in honor of the person who passed.
Take Control of Your Finances
While an inheritance could help you tackle financial challenges, it won’t necessarily change your personal relationship with money or solve all your problems. If you’re looking for a personalized assessment and plan, but aren’t ready to hire a financial advisor, consider a free budget and debt counseling session with a certified counselor. The counselor can assess your current situation and help create a plan for achieving your financial goals with your inheritance in mind.