Inheriting Assets From A Family Member? – Here are your Options
This year (more than any other year) I have had a large amount of current and new clients inherit assets from family members. In my experience, this inheritance is from non-spouses – aunts, uncles, parents, etc. – which means that there are specific rules that apply to the actual distribution of these assets. This is in comparison to a spouse passing away, in which case the surviving spouse is able to take over control of the assets as if it was their own from the beginning (for non-retirement accounts this may be different depending on ownership and transfer upon death status).
In any event, the two most common questions I receive when a client inherits money is ‘what should I do with it?’, and ‘how will I be taxed on this?’.
So, today we will briefly walk through the common accounts a person may inherit, and the planning techniques I help clients implement to remain efficient from a tax and investment planning viewpoint.
Pre-Tax Retirement Accounts – IRA, 401k, 403b, etc.
In my opinion, the most common asset received is some sort of pre-tax retirement account from a non-spouse – meaning that the original owner of the account made contributions on a pre-tax basis, and when they took distributions in retirement, they were 100% taxable as income.
Prior to the Secure Act enacted in 2020, if you inherited a pre-tax retirement account from a non-spouse you could stretch out the distributions over your life expectancy using tables provided by the IRS. This was advantageous as you were able to stretch out the tax implications over many years.
However, with the new rules under the Secure Act the recipient of this pre-tax account now has to withdraw the entire account balance and pay appropriate taxes on the distributions by the end of the 10th year of inheriting the account. Currently, there are no rules that you need to take a specific amount out each year, however, it may be more efficient to do so, rather than taking a lump sum in year 10 (could be a large tax implication).
For an individual or couple in their highest earnings years, this type of situation could be detrimental to their tax situation, as taking distributions could bump them up one, or even two marginal tax brackets. This is one of the reasons I firmly believe that pre-tax retirement accounts are the worst assets to die with from your beneficiary’s perspective.
A few options to make this process efficient:
- Max out contributions to your own pre-tax retirement accounts to counteract the distribution you will take from the inherited account. In some cases, if you need to take our $20,000 and you can contribute $20,000 more to your own pre-tax account, the tax implication could be a wash depending on your existing contribution level
- If you are already maxing out your pre-tax accounts, do your best to determine how much you can take from the inherited account without bumping yourself up to the next marginal tax bracket
- If you anticipate that you will experience a low-income year, (or years) it may be smart to take a larger amount out, or maybe even the entire account balance in this one year (or over the low income years)
- For example, let’s say you inherited a $100,000 pre-tax account from your parents, you are currently in the 24% marginal tax bracket ($100,525-$191,250 for single filers in 2024), and you plan to retire next year. You could wait until you retire, hold off on collecting Social Security and any other income from your own accounts, and take the full distribution from the inherited account.
- Factoring in the standard deduction, you could keep yourself in the 22% marginal tax bracket and be done with the inherited distributions. You just generated your income for the years and strategically paid less tax than you would have if you waited to take the distribution over 10 years, factoring in additional retirement income by that time
- Other examples of low income years could be taking a step back from work, going on a sabbatical, etc.
- For example, let’s say you inherited a $100,000 pre-tax account from your parents, you are currently in the 24% marginal tax bracket ($100,525-$191,250 for single filers in 2024), and you plan to retire next year. You could wait until you retire, hold off on collecting Social Security and any other income from your own accounts, and take the full distribution from the inherited account.
After-Tax Retirement Accounts – ROTH IRA, ROTH 401k, ROTH 403b, etc.
Given that ROTH IRAs were only established in 1998, I do not see too many folks inherit a ROTH as compared to pre-tax. But in the event they do, the distribution of this type of account is much easier from an inheritance perspective.
With ROTH’s, the contributions are made after-tax – meaning the individual paid taxes on the contributions, which in turn allows the growth and eventual withdrawal of these assets come out all tax-free (as long as the 5 year rule has been satisfied – over age 59 ½ & account has been open for 5 years).
Moreover, when a non-spouse inherits a ROTH account, it is true that they must deplete the balance in the account by the end of the 10th year, but the distributions are not taxable since the funds are ROTH (after-tax). Reminder ROTH is different than making general after-tax contributions to a retirement plan – with general after-tax contributions the earnings are subject to tax.
In any case, if the funds are not needed, I often suggest clients keep the funds invested until the point they have an intended purpose, or until the end of the 10 years. If the funds are left as is for 10 years, they will continue to grow all tax free!!
Taxable Investment Accounts – i.e. brokerage account, stock account, etc.
As a refresher, these types of accounts are funded by the original owner with after-tax monies that are invested, and upon withdrawal are subject to either long-term or short-term capital gains rates depending on the holding period of the underlying assets.
Similar to inheriting a ROTH account, inheriting a taxable investment account as a non-spouse can be advantageous from a tax and flexibility perspective.
Here’s why – for example let’s say Mom and Dad bought XYZ stock back in 2005 for $10,000 – this will be the cost basis in the account. In 2024 the account is now worth $150,000. You are their only child and you are listed as the beneficiary on the account – transfer on death (TOD) registration. If Mom and Dad sold the whole account, they will need to assess their capital gains tax liability on the $140,000 gain ($150,000 value - $10,000 initial cost). Let’s say their capital gains rate is 15% based on their total taxable income for the year.
In 2024, prior to liquidating the account, Mom and Dad pass away simultaneously - the $150,000 stock position is now passed to you as the sole beneficiary via transfer on death (TOD) registration. Under current tax laws, when you inherit these shares, ($150,000 in this example) you actually receive a step-up in cost basis on the account position as of the account owner’s date of death. So instead of the cost basis on the account being $10,000, the cost basis is now $150,000, and any gains realized are treated as long term capital gains.
So, you could go sell the $150,000 stock position after your parents pass away and pay $0 in capital gains taxes. Again $0. Not a bad deal – and the asset passes outside of probate with the TOD registration.
Compare this to inheriting a pre-tax account and being required to withdraw the entire balance and pay income taxes at your respective rate (over 10 years) during your highest earnings years! No thank you.
In conclusion, if you are expecting an inheritance from a family member (or have already received one), it is crucial to have a good understanding of the type of assets you have (or could) receive, and what the tax implications are for these assets upon inheritance.
There is a ton of planning that can be done to make this a smooth transition from a tax and investment planning perspective as your situation accepts these new assets.
When in doubt, make sure to consult with a CFP® professional and qualified tax professional prior to making any decisions.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.
Some IRAs have contribution limitations and tax consequences for early withdrawals. For complete details, consult your tax advisor or attorney.
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. This does not represent any specific product.