Financial windfalls can be a life-changing amount of money, whether it’s winning the Powerball jackpot or inheriting your grandparents’ estate. Receiving or inheriting a large sum of money can allow for so many possibilities in life.
There are several ways to handle a windfall of cash, though, if you’re ever lucky enough to receive one.
The Average Inheritance in the United States
The average American inheritance across all age groups and incomes between 2001 and 2019 was just over $12,000, according to a University of Pennsylvania Inheritances by Age and Income Group study. That figure is lower as a result of the vast majority of Americans who received no inheritance at all. But among those who did receive one, the average was about $184,000.
How To Handle the Three Most Common Inheritances
CNBC reported that inheritances generally come in three primary forms: cash, real estate and investments.
This is the simplest form of inheritance to receive, as long as you’re not receiving an astronomical amount. Luckily, in 2023, you won’t owe federal taxes on any cash you inherit up to $12.92 million. In this case, you might want to splurge on something fun.
Then for the rest, it’s advised that you create an emergency fund if you don’t already have one, pay off any high-interest debt that’s eating away at your finances, and start investing in stocks and/or funds.
“Cash is the easiest type of inheritance to receive,” said Pratik Patel, managing director and head of family wealth strategies with BMO Family Office. “We’re not worried about the tax consequences of a sale. We’re not worried about basis. It’s your money to do as you see fit.”
Fortunately, thanks to a rule known as a step-up in basis, you likely won’t owe any tax on property you inherit — not at first, anyway.
The tax rules are such that the value of an inherited home resets when the owners die. For example, if your parents paid $200,000 for a house and sold it for $700,000 while they were living, they’d owe tax on the $500,000 gain. Alternatively, when they die and leave the house to you, the value of the house for you (which is known as your basis) is the fair market value of the house at $700,000. If you then sold it for that amount, you wouldn’t realize a gain as far as the current IRS rules are concerned.
It’s worth noting that while it may seem like a good idea to hold on to an inherited property in a slow housing market, conditions can change which might cause you financial losses.
“There’s the step-up in basis at the time of death, but the estate settlement process can drag on for six or 12 months. Real estate values change and the market can change” said Clay Ernst, executive director, financial planning at Edelman Financial Engines.
Real estate taxes, maintenance, any applicable utilities and more will reduce your cash flow until you sell the property.
Just like real estate, the step-up in basis applies when you inherit any investment account. So, even if your parents bought Microsoft stock for $50 a share way back when, you’ll inherit the shares at today’s market value and won’t owe any tax. If you make any gains on the investments after inheriting them and then go sell them, you’ll owe taxes on just the gains.
Rules get a bit more complicated when it comes to inheriting retirement accounts like 401(k)s or traditional IRAs. Since 401(k) contributions are pre-tax (unless it’s a Roth IRA), now you’ll be liable to pay taxes on any withdrawals from that account since your relative never paid taxes on the invested money. You’ll want to be careful about when you pull the money out, based on your current income tax bracket.
“Now I have to pay tax when I pull that money out,” said Patel. “And when I pull that money out, that stacks on top of my income I’ve already earned. If I’m in my peak earning years, that’s subject to potentially the highest tax rates in a given year.”
In most cases, the IRS gives you a 10-year window to take that money out, which gives you flexibility and time when it comes to smart tax planning. It’s important to work with a tax professional whenever (or if ever) you receive an inheritance so that you can strategically keep as much of the inheritance as possible.
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