Heirs Should Treat Windfall With Special Care

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.

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."

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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.

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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If you are one of several beneficiaries of the IRA, you should split the account into separate inherited IRAs. If you don't split the IRA by December 31 of the year after your parent's death, your RMD will be based on the life expectancy of the oldest beneficiary—requiring larger distributions and depleting the account more rapidly. By splitting the account, each heir can use his or her own life expectancy. Be sure to name beneficiaries for your new IRA.

Take special care if your parent named a charity as a beneficiary along with you and other beneficiaries. You must split off the charity's portion by September 30 of the year following the account owner's death. If you don't, the account must be emptied within five years after the owner's death. (For more information on inherited IRAs, read IRS Publication 590, Individual Retirement Arrangements (IRAs), at www.irs.gov.)

If you inherit a 401(k), the distribution rules typically are similar to those for IRAs. However, some plans are more restrictive. For example, a plan could require that the assets be withdrawn within five years after the account holder's death rather than over the beneficiary's life expectancy. The simplest option is to roll the money into an inherited IRA.

Determine the future of the family home. Your first concern should be securing and maintaining the house until you, and other heirs such as siblings, decide what to do with it. If no one is living in the house for a period of time, consider installing an alarm system if there isn't one already. Check in periodically to make sure nothing is amiss.

The beneficiaries—or the executor of the estate—will need to make sure that utility, tax and any mortgage bills are paid. Until the estate has cleared probate, the bills will be paid from the estate. Pearson suggests calling the homeowners insurance company to check on the insurer's requirements after the death of a homeowner. "Some companies don't want a house sitting empty for six months or more," Pearson says.

If there's still a mortgage, advise the lender of the owner's death. The beneficiaries, or the executor, must keep the payments up to date to avoid foreclosure.

You and your siblings may have an emotional attachment to the house, but if none of you wants to live in it, you'll need to decide whether to sell it or rent it out. "In a lot of markets, you are better off selling rather than renting, especially if you include the cost of property taxes and insurance into your calculations," Pagliarini says. The benefits of selling could grow if the house still carries a mortgage or a home equity line of credit, or requires substantial repairs—the rent you can charge may not cover all of the costs.

The value of the house is included in the estate for purposes of determining whether any estate tax is due. However, heirs get a break on capital-gains taxes. When you inherit a house, the value on which gain or loss is based is the fair market value of the property on the date of death of the previous owner (or in some cases, six months after that date). This "stepped-up basis" rule means you won't owe tax on all the appreciation during the period your parents owned the house.

Suppose you inherit a house that your parents bought 30 years ago for $50,000. When your last surviving parent dies, the house is worth $400,000. You will not owe capital-gains tax if you sell the property quickly. If you hold on to the property and sell it for $475,000 in a few years, you will owe capital-gains tax on $75,000.

If one sibling wants to live in the home, the division of the assets should include the value of the house. Say there are four siblings inheriting a total of $4 million, including a house valued at $1.5 million. If one heir wants to keep the house, he or she would have to pay the other heirs about $166,000 each if the heirs want to keep the split even.

Reevaluate your investment strategy. Perhaps your parents held significant amounts of cash or tax-exempt municipal bonds, while your target allocations include a larger share of stocks. "You want to make sure the new assets are coordinated with your existing investment strategy," Pagliarini says.

One break: As with the house, heirs get a step-up in basis for inherited stocks, bonds and mutual funds. If you want to diversify the assets by selling securities in a taxable account, you won't pay capital-gains tax unless the securities have increased in value between the day of the parent's death and the date of the sale. (If a security loses value, you can use the loss to offset any capital gains in your portfolio.) You won't owe tax if you reallocate holdings in an inherited IRA, either.

Often, a parent's stock holdings are as laden with emotion as the family china. Adult children may remember their parents discussing their favorite stocks at family dinners, for example. "It can be difficult to part with the stocks because they hold sentimental value," says Jack Riashi Jr., a certified financial planner for Bloom Asset Management, in Farmington Hills, Mich.

Riashi recalls one client who inherited a portfolio that was 35% invested in ExxonMobil stock. Although the stock paid a nice dividend, it took time for Riashi to persuade his client that diversifying the portfolio was safer in the long run. They scaled back the ExxonMobil stock over a couple of years, to about 4% of the portfolio.

If an investment portfolio must be divided among two or more heirs, Riashi says it's best to transfer equal amounts of shares of each fund or stock to each beneficiary's account. And make sure the pro-rata division takes place separately for the taxable account, traditional IRA and Roth IRA, he says. A sibling who gets $500,000 in a traditional IRA, and must pay income tax on any withdrawal, would fare worse than the sibling who gets the $500,000 in a tax-free Roth.

Before you spend too much time reallocating investments, you and a financial planner should discuss possible uses for the money. Perhaps you want to use some of it to start your own business, retire earlier than planned or pay for a grandchild's college education. Inherited assets could open the door to an extra tax break if they allow you to divert more of your salary to a company 401(k) or a deductible IRA.

Check for any tax bite. Most assets you inherit come to you income-tax-free, including life insurance proceeds and the value of stocks, bonds and real estate. A major exception: Withdrawals from an inherited traditional IRA or annuity will be taxed to you exactly as they would have been taxed to the original owner.

You'll owe federal estate tax only if the estate is larger than $5.34 million in 2014 (up to twice that if the first parent to die preserved any unused estate-tax exemption). But if you live in a state with its own estate or inheritance levy, the estate or heir may owe state tax.

You also could owe income tax for any income that was owed to your parent at the time he or she died. This includes any salary or unpaid interest or dividends. If the estate owes federal estate tax, you may be able to take a tax deduction for what is known as "income in respect of a decedent."