A common question that comes up for retirement planning is, “what changes should I make if I expect an inheritance?”
People who may receive an inheritance have a great question. If you think you are going to receive an inheritance, why save as much?
It’s extra years of working when you could be doing something different.
Perhaps you could work a less stressful job, pay for your kids to get a better education, or simply enjoy spending more – on yourself or charity.
But, what if you don’t receive the inheritance as planned?
Then, you are short on your own retirement funds. It’s tough to make up for lost time.
Compounding works best when you have more time, and starting to invest more later in life can work, but it’s much harder than starting early.
Let’s talk about how to save, spend, and invest when you expect an inheritance, but can’t ever be 100% certain you will receive anything.
Spoiler Alert: For the most part, I think you should not count on inheritances and ignore them.
Expect an Inheritance? Inheritances Can Change
Why ignore inheritances?
Because they can change!
Yes, I get it. Your mom’s wealthy. Your entire family is wealthy. You’ve never had to worry about money.
Or, maybe your family saved well, is frugal, and will be to the day they die. You expect a sizeable inheritance.
Still, life happens. Relationships change. Investments go up and down, sometimes very down. Health declines.
Life is unknowable.
Everybody who has a good, or at least solid, relationship with their family wants to believe it will be that way forever.
Let me tell you – it doesn’t always turn out that way.
Sometimes mothers change their power of attorney documents and sign a new Will.
Other times, siblings get written out of a Will.
Family members can also use it as a control tactic.
People get remarried and write children out of the will.
Nobody wants to think about relationships negatively changing, but it happens.
Kids are born. People divorce. People remarry. People make mistakes. Individuals get vengeful. People lose control and grasp onto ways to maintain control. The list is never-ending.
Relationships are messy.
Everything could be going normally for an entire lifetime, dad dies, mom goes to assisted living, meets the love of her dreams – and instantly, of sound mind and body, writes you out of the Will.
People never think it will happen to them, but it happens.
Investment Values Change
When I ask people to tell me what they are inheriting, most people can’t tell me. Most have a vague idea of the type of accounts and almost nobody knows how it is invested.
Even if they knew how it was invested, what if the investments change?
What if someone had a taxable brokerage account and decided to buy a property? What if property values go down?
What if someone had their entire investment portfolio in an individual company and that company went bankrupt?
What if someone had most of their net worth in a few individual stocks that declined 50% and never recovered?
Like relationships, investments change. Values go up and down. Investments are bought and sold.
Maybe life is going along well, dad’s memory is slipping, and he decides to trade in his lifetime of index investing for the next hot stock tip that ends up going bust.
It might be rare, but it could happen.
Do you want to stake your future on an aging population in a world of uncertainty?
Long-Term Care Expenses
Ah, yes, long-term care expenses. No article about inheritance would be complete without them.
HEALTHCARE IS EXPENSIVE. HEALTHCARE COSTS ARE UNKNOWABLE.
I apologize for the yelling, but I needed to accentuate my point.
I’ve known people who have needed memory care for 10+ years. Memory care can cost $100,000+ per year. That’s $1,000,000+ over those 10 years.
Even if your family member has long-term care insurance, do you know what it covers? Do you know how much it pays out? Do you know how long it pays out?
Many policies are limited in what they pay. Many have a pool of benefits that, once used, no longer pay.
What happens when the policy is fully used?
Perhaps your anticipated inheritance is used next.
For me, long-term care expenses are the biggest wildcard.
You can have the most stable family on earth with a solid investment strategy, and long-term care expenses can still poke a hole in your plan.
It’s also the type of event with a wide variety of outcomes. You might need no care, a few months of care, or a decade-plus of care.
Costs can range from nothing (think drop dead from a heart attack) to a few thousand dollars with a Stage IV Pancreatic Cancer diagnosis (often six months or less), to millions of dollars with a Parkinson’s diagnosis (near-normal life expectancy, but needing an increasing level of care).
Nobody knows what card they will be dealt.
Who Controls the Inheritance?
The next factor to consider is who controls the inheritance. And going back to the fact that relationships change, how could who controls it change in the future?
If you haven’t seen the Will or trust, or even if you have, sometimes inheritances are anything but clean and easily divisible.
Do You Co-Own Certain Properties or Accounts?
Even if you think you are receiving your inheritance outright, it could change.
Does your family own a property that could be co-owned by you and others?
Vacation homes are a favorite to leave to multiple family members. Not only is that an asset, but it’s also a liability. It requires upkeep, insurance, and other ongoing expenses.
What if you want to sell and other family members don’t? Can you sell your portion?
Maybe it’s not a vacation home. Instead, you receive a rental property you co-own with other family members.
What happens when you want to sell it for a large lump sum and your family members want to keep it for rental income?
For example, imagine if a family member has a major health event and needs to sell it to cover their medical bills because the rental income isn’t enough. Who ultimately gets to decide when you sell it and for how much?
It’s tough to decide what to do with a property when only one or two people need to make a decision. Imagine if multiple siblings, spouses, and even kids were influencing the decision.
Or, maybe, you will inherit an irrevocable trust with siblings and you named as beneficiaries, and it will be managed as one trust instead of split for each individual beneficiary at death.
Who decides the allocation, investments, and distribution from the trust? The trust will specify under what scenarios distributions can be made, but it’s still up to the trustee to do it.
Is There a Trustee?
If the inheritance is not being received outright, will it go to a trust with a trustee? If so, who is the trustee? Is it another family member or professional trustee?
Do you know what the trust says about distributions?
Many trusts are set up to allow income or 5% of the value of the trust to be distributed each year with certain exceptions for principal distributions, such as education, health, and other situations where additional money may be needed for good reasons.
Trustees have to follow the rules of the trust, but they often have some discretion about how much to distribute and when.
Do you want to leave it up to a trustee to decide when you receive an inheritance?
That’s another reason to not count on an inheritance when planning for your own retirement.
When Will You Receive It?
As I alluded to earlier, an inheritance often is not an instantaneous event. It’s not like a loved one dies on day 1, and on day 2, you receive the inheritance.
Even if you receive it outright, it often can take around a year to settle an estate and make distributions.
If it’s more complicated, it could take longer.
Assume it’s at least a year from death until you receive it, but even then, it could go to a trust for your benefit.
In those scenarios, what does the distribution schedule say? It’s not uncommon for someone to elect to have income distributed annually, but keep the remainder in the trust until age 35 or even for life.
Certain types of trust provide creditor, bankruptcy, and divorce protection. Knowing this, some parents will have the trust continue until their children’s death.
Depending on how the trust is written, there can be flexibility around when and how much can be distributed, but the main point is that you may not receive the full amount you want or need at the exact time you want or need it.
Most people see what a family member has and splits it in their mind between other family members, but depending on how the estate plan is written, it may not be instantaneous.
Plus, sometimes trusts are set up only to provide for one person. A trust may specify that if you die before your spouse, your spouse gets none of the trust and it goes to another person.
If you were counting on the trust for retirement, and then died the day after retirement, your spouse would be in an awful situation.
Even if you knew when you were going to receive it because you read the estate plan, remember those details can change – just like relationships.
Tax Impact of Inheritance
Lastly, consider how your inheritance will be taxed.
Even if the estate does not owe taxes, which might reduce your inheritance, how will the assets you receive be taxed?
If you are inheriting an IRA, future distributions will be taxable as ordinary income. If you are in the 24% tax bracket, taking $100,000 might mean only receiving $76,000 after taxes.
If you are inheriting a brokerage account, assets normally receive a step-up in cost basis, meaning if you sold them the same day as death, there would be little to no capital gains tax. The reason for this is because if your mom bought a stock for $10 and it was worth $100 at death, the cost basis of $10 usually does not carry over, but gets “stepped up” to the fair market value on the date of death. In this case, that was $100. If you sell $100 and your cost basis was $100, your gain is $0.
There are circumstances where assets don’t receive a step-up in cost basis at death. If you are inheriting an irrevocable trust that wasn’t included in your grandmother’s estate and you are inheriting it from your mom, your assets may not receive a step up. In that case, if your grandmother bought a stock for $10 and you inherited it when it was worth $500, you might have a $490 gain if you wanted to sell it. In that case, you are paying capital gains taxes, which can be 0%, 15%, or 20%, depending on your other income.
Annuities are another beast. Because annuities provide for tax-deferred growth, the earnings are taxed as ordinary income. If you took money from an annuity in a lump sum, you would owe ordinary income tax on the growth.
This often catches people off guard because they might have tens of thousands of dollars of more of income in a year being taxed.
There are often other ways to take the annuity payout over a number of years to spread out the tax liability, but then it goes back to how soon you might want or need the funds.
The key is to know which types of assets are owned, whether any estate taxes may be due at death, and how the assets you are inheriting might be taxed.
How to Account for an Inheritance
I wouldn’t change much in life to account for an inheritance. I’d continue saving, investing, and spending as if my life did not depend on receiving it.
If you are later in life and wanted, you could spend on the upper end of your comfortable spending level, knowing that if the inheritance is not received, you may need to reduce your spending later.
Or, if you are saving, perhaps you save on the lower end of your savings rate, knowing that you can increase your savings rate later if you don’t receive the inheritance you anticipated.
I wouldn’t personally do this, but it’s a reasonable tradeoff if you felt like you had to make some adjustment to account for the inheritance.
There is a range of spending and saving levels for most people. I wouldn’t make any drastic adjustments if you anticipate an inheritance because mistakes are usually made when people make extreme adjustments.
It’s easier to course correct with minor adjustments while still feeling like you are doing something.
Summary – Final Thoughts
Receiving an inheritance is a great gift.
I’d never count on an inheritance. Too much can change in life.
Relationships can change, investments can be sold or bought, and long-term care expenses can destroy an otherwise healthy financial plan.
On top of that, knowing who controls an inheritance can be complicated.
You might inherit property to be managed with other family members. You might become a trustee and face awkward family dynamics. You might have a trustee in charge of your trust. That person could be a family member or a professional trustee.
The trust might limit when and how you can receive distributions.
Lastly, there is the tax factor. How will the assets be taxed? What you see is usually not what you get. You need to account for taxes first.
If you feel like you must make a change, perhaps make a minor adjustment. Spend a little more if later in life or save a little less if early in life.
I wouldn’t personally do this, but financial decisions are personal. You have to choose what is best for your life.