5 Ways a Financial Advisor can help you Plan for Inherited Wealth
While it isn’t essential that inheritors work with a financial advisor, bringing in an advisor who is a CFP® and has experience working with inheritors can be an asset to your family. If you’re looking for more information about what to do when you inherit wealth, you can download Sunnybranch’s FREE Guides for Inheritors or Schedule a Call With Katherine to learn how Sunnybranch can help you build a plan to manage inherited wealth.
Understanding How to Plan for an Inheritance
Hiring a financial advisor to help with your inheritance can have benefits beyond deciding what to do with inherited wealth.
Just because you inherited money, it doesn’t mean you can paint over your current financial situation. Before receiving an inheritance, heirs should review their finances and wealth to identify areas to be updated or changed. A financial advisor can help you get your money situation organized and identify areas of concern that should be addressed.
A pre or post-inheritance review with a financial advisor may include analysis of your:
Investment Accounts
Retirement Accounts
Charitable Giving
Real Estate
Debt
Annual Income and Expenses
Taxes
Insurance
Employer Benefits
Estate Documents
While your finances may have been well organized pre-inheritance, a significant increase in your level of wealth can necessitate changes. When navigating the inheritance process, an advisor may suggest focusing updates to your financial situation in five areas:
Protecting your inheritance and passing inherited wealth to heirs.
Your pre-inheritance estate plan may not be sufficient to handle the distribution and protection of millions of dollars upon your death.
If you received an inheritance as the result of a loved one’s passing, you should review your estate plan with a qualified attorney. A financial advisor can assist in this process by helping you gather information about your pre and post-inheritance finances and presenting it to the attorney. They can also sit in on meetings to help you understand and remember key concepts and options your attorney presents.
This review should include a full accounting of your net worth and a discussion of your wishes for asset distribution after your death. While leaving everything to your children may still be a viable plan, the potential for minor beneficiaries to inherit a multi-million dollar estate needs to be planned for. Your options may include creating trusts with financial guardrails and/or appointing guardians and conservators who are comfortable managing significant investment portfolios and will keep the best interests of your children in mind.
This process also presents an opportunity to review increasing charitable giving through your estate plan. There are many methods to give through your estate plan, but the most straightforward is a bequest of cash or assets in your will. Moving into a new level of wealth necessitates a review of your impact priorities and the role you want to play in creating a positive impact with your inheritance.
2. Managing tax consequences of inherited assets.
There are different kinds of taxes you will deal with during the estate settlement and inheritance process. Many estates will have to pay taxes on income earned to the estate during the settlement process. Others will be subject to estate tax at the Federal and/or State level.
Inheritors in some states may also have to pay taxes on inherited wealth.
And you still may not be done. Some forms of inheritance have embedded taxes that can be due years after you receive them. A financial advisor should be able to work in conjunction with your accountant to help you manage these taxes and build a plan to minimize your tax exposure in the early years of managing an inheritance. This especially true for inheritors with inherited IRAs and those who will not receive a step-up in basis on some or all inherited assets:
Inherited IRAs
The SECURE Act of 2019 requires that most non-spousal beneficiaries who inherit IRA assets on or after Jan. 1, 2020, are required to withdraw the full balance of the account within 10 years. It also requires that inheritors of IRAs take annual required distributions if the deceased owner of the account had already started their Required Minimum Distributions (RMDs).
These withdrawals will be treated as taxable income and can create a tax headache for inheritors. It is advisable to build a plan for these withdrawals if you have inherited a large IRA to avoid either a tax penalty or an extremely high tax bill in year 10.
Step-Up in Basis
Many inherited assets receive a step-up in basis, allowing heirs to sell them without incurring capital gains tax. This is not true for all inherited assets and heirs who inherit a decedent’s cost basis will have an additional layer of tax planning. Unsure if you will get a step-up in basis? Contact Katherine to talk more about the details of the estate you are inheriting.
A "step-up in basis" refers to a tax benefit that can occur when someone inherits an asset, such as real estate, stocks, or other investments, from a deceased individual.
Here's how it works:
Original Basis: The basis of an asset is typically its original purchase price + the value of any significant improvements or reinvestments. For example, if someone bought a house for $200,000, that is the original basis for the property.
Inherited Asset: When an individual inherits an asset, the tax code allows for a "step-up" in the basis of that asset to its fair market value (FMV) at the time of the original owner's death. This means that for tax purposes, the beneficiary's starting point for measuring capital gains or losses is the asset's value on the date of the original owner's death, not the original purchase price.
Capital Gains Tax Implications: If the beneficiary later sells the inherited asset, the capital gains tax is calculated based on the difference between the sale price and the stepped-up basis. This can result in significant tax savings, as any appreciation in the asset's value during the original owner's lifetime is not subject to capital gains tax.
For example, suppose you inherit a house that was originally purchased for $200,000. Its fair market value at the time when your loved one died and you inherited it was $300,000. If you later sell the house for $320,000, you would only pay capital gains tax on the $20,000 increase in value from the stepped-up basis of $300,000, rather than on the entire $120,000 increase from the original purchase price of $200,000.
The step-up in basis is a valuable tax benefit for beneficiaries because it minimizes the potential capital gains tax liability on inherited assets. However, this provision applies to assets inherited through a will, through intestate succession (when there's no will), or certain types of trusts. It does not apply to gifts of assets made before the original owner's death or to assets transferred into certain types of trusts.
3. Building an investment portfolio and passive income streams using inherited wealth.
Your pre-inheritance investment portfolio may require updates to reflect changes in your investment priorities after receiving inherited wealth.
Your financial advisor should conduct a thorough review of your risk tolerance, time horizon, and financial goals. This review will help them determine the appropriate allocation of conservative and growth-focused assets in your portfolio, but also recommendations for the types of funds in which to invest.
Your recommended portfolio allocation will be different if you intend to keep working than if you want to retire now and live off income from inherited wealth. If you are looking to generate income from your investment portfolio, an advisor can help you generate a target by analyzing your portfolio value and your financial goals. Investment options including CDs and money market funds, bonds, dividend stocks, real estate investment trusts, and income-focused mutual funds and ETFs may be used along with systematic portfolio withdrawals to help you generate income to fund your lifestyle needs.
While generating income from the portfolio is an important goal, many inheritors will also want to focus on preserving principal to pass down to future generations. Always remember that spending down the principal amount of your investment means that you will likely have a lower ability to generate income in the future.
4. Expanding your inheritance’s positive impact through investing and philanthropy.
If you are an inheritor who has entered a new level of wealth, you may be interested in using your wealth to create a positive social impact. This can range from starting to make annual contributions to nonprofit organizations to deciding that you want to build a plan to invest some of your inheritance in below-market rate impact investments and give the rest away. Wherever you are, having a financial advisor with expertise in charitable planning can help you build out your values, impact priorities, and philanthropic plan.
On the investment side, there are many different options available to create a positive impact with your inheritance. A financial advisor may suggest creating a positive impact with your wealth through the following investments:
Socially Responsible Investing (SRI)
SRI involves screening investments to avoid companies or industries that have negative social or environmental impacts. SRI funds may focus on issues like environmental sustainability, labor practices, or corporate governance.
Environmental, Social, Governance (ESG) Investing
ESG funds evaluate companies based on their performance in environmental, social, and governance categories and invest in companies that meet specific ESG criteria. ESG funds can be broad-based or specialized, targeting specific environmental or social issues.
Impact Funds
Impact funds are designed explicitly to generate both financial returns and measurable positive social or environmental outcomes. Impact investments may include areas like clean energy, affordable housing, education, healthcare, or poverty alleviation.
Microfinance and Community Development Investments
These investments are made in organizations including community banks and community development financial institutions (CDFIs) that provide financial services and support to underserved communities and can empower small entrepreneurs and contribute to economic development.
Green Bonds
Green bonds are debt securities issued by governments, municipalities, or corporations to fund environmentally beneficial projects, such as renewable energy infrastructure or clean water initiatives.
Direct Impact Investments
Direct Investments are investments made in companies that are working to create positive impact in a variety of different areas. Common investments include renewable energy and clean technology, affordable housing, education and workforce development, healthcare, and conservation.
5. Updating your insurance needs after inheriting wealth.
Updating your insurance after a large inheritance is a responsible step to protect your assets and financial future. Your financial advisor should help you evaluate your needs in several different areas of insurance coverage, including:
Life Insurance
Depending on the size of your inheritance and your plans to continue working (or not), your life insurance policies may need to be increased. Life insurance is an important vehicle to provide for your family in case of death. For those who inherit estates in the tens of millions, whole life insurance may also be a useful tool to accumulate a source of tax-free income and/or provide your beneficiaries with a cash inheritance upon your death.
Homeowner’s Insurance
If your inheritance includes a new home or property, you will want to ensure you have full coverage under your own name. Inheritors may have sticker shock as they learn the insurance and maintenance costs associated with new properties and should carefully consider if they have the resources to maintain inherited homes.
Valuable Property Insurance
Special property such as artwork, jewelry or collectibles will not be covered under a standard homeowner’s insurance policy. Inheritors of these types of special property should consider purchasing a Valuable Personal Property plan to ensure these assets in case of theft or damage. These plans are generally expensive, but are the only way to protect items that often have significant financial and emotional value.
Umbrella Insurance
Umbrella insurance provides liability coverage in case you are sued. Generally, it is advisable to have an umbrella policy in place that is at least equal to your total net worth. Umbrella insurance often gets forgotten, but inheritors of large estates may easily become targets for lawsuits and should ensure they are protected in case of civil action against them or their family.