Over the past 35 years, our firm has worked with hundreds of people who have inherited investments from their parents. The decisions made with recently inherited assets can have significant permanent tax implications. Understanding the negative consequences and the different available opportunities can have positive benefits that can last years into the future. Many strategies can be beneficial to implement when inheriting assets. The following article is designed to share tax minimization techniques that can be implemented following the loss of a parent.
After receiving an inheritance, it is worth creating a list of each separate inherited asset. For simplicity, I will focus exclusively on inherited investment accounts. One of three actions can take place for each investment account: spend it, keep it or transition it. The appropriate action for each asset is dependent on a variety of variables, including potential tax implications.
One common type of investment people often inherit from their parents is an individual retirement account (IRA). When an IRA is inherited from a parent, generally, any amount distributed from the IRA is subject to federal and potentially state income taxes. IRAs that are inherited from parents need to be fully distributed within the 10 years following the death of the parent. You can choose to distribute all of the money in one year, or you can choose to take smaller distributions over several years as long as the entire balance is withdrawn by the end of 10 years. Because each distribution is subject to taxation in the year it is distributed, it frequently makes sense to minimize the taxes by taking partial distributions over the 10-year time frame while avoiding pushing yourself into an unnecessarily high tax bracket in any one year.
Another common asset to inherit is a Roth IRA. Like an IRA, a Roth IRA also needs to be distributed within 10 years following the death of the parent. However, unlike IRA distributions, Roth IRA distributions are typically income-tax-free. Due to the income-tax-free benefits available on distributions, it can be more attractive to keep inherited Roth IRAs invested the duration of the 10 years following the death of the parent. By keeping the inherited Roth IRA invested for as long as possible, you can reap the benefits of tax-free growth over the 10 years.
The final type of investment that is common for a child to inherit includes non-qualified investments. Non-qualified investments can take many different forms, including inherited bank accounts, brokerage accounts, and other types of investments that are not within a qualified retirement account, such as an IRA or Roth IRA. Generally, non-qualified investments do not have specific distribution rules and can be liquidated as desired. Despite the flexibility, non-qualified investments typically are not the No. 1 choice for people investing for longer-term retirement purposes due to potential annual tax burdens. These tax impacts may include but are not limited to interest income, dividends, and periodic capital gains when appreciated investments are liquidated.
Once you have determined which investments to spend, keep, or transition, the next step is to decide where to place the proceeds of the investments you intend to transition. If we assume you intend to invest the transitioned investments for your own retirement, it is important to take an inventory of all tax-efficient investment vehicles available. This list can include IRAs, Roth IRAs, 401(k) plans, Roth 401(k)s, health savings accounts (HSAs), and other work-related retirement plans.
For qualifying individuals, the current annual maximum amounts that can be invested toward some common tax-efficient plans are listed below:
- 401(k), 403(b), 457(b), Roth 401(k): $19,500 (under age 50) or $26,000 (over age 50)
- IRA/Roth IRA: $6,000 or $7,000
- HSA: $3,600 or $4,600
- Total: $29,100 or $37,600
A single individual under 50 could qualify for $29,100 in total tax-favored investments in 2021 between their workplace retirement plan, IRA/Roth IRA, and HSA. If they were married and their spouse had access to similar options, the total annual tax-favored contributions could rise to $58,200. For qualifying single individuals over 50, the catch-up contribution rules increase the totals to $37,600, and married couples could set aside a total of $75,200 per year. Depending on one’s employment, there may be additional opportunities available above and beyond what is mentioned here. The dilemma for some people becomes how to maximize these tax-favored investments on a limited budget.
To afford to maximize the different accounts mentioned above without compromising your income requires three simple steps. First, change your employment withholdings to maximize your most desirable tax-favored investments based on what you qualify for. Second, start the maximum automatic contributions to your and your spouse’s IRA/Roth IRA, assuming you qualify. Third, start an income stream from your least tax-friendly inherited investment that replaces the income now being funneled into your workplace retirement plans and IRA/Roth IRA. Over time, this strategy will reduce your least tax-friendly inherited investments while simultaneously increasing your tax-favored investments by a similar amount. In other words, you will have larger amounts in a tax-friendly environment and less money in tax-disadvantaged investments, and you do not have to compromise your current income to implement this strategy.
How adult children handle their inheritances can play a significant role in how much money they can spend in their future. With some creative planning, beneficiaries can create a more tax-efficient investment strategy that can last their lifetime without having to make any compromises to their lifestyle. It is important to work with an advisor when implementing these strategies to help determine the most appropriate investment vehicles available based on your unique circumstances.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.