What to do about income tax, estate planning, investing, discretionary spending, charity, and privacy
By Alan G. Orlowsky, J.D., C.P.A.
Receiving a large bequest or gift might change your life. At the very least, your financial situation will improve dramatically. Your emotional reactions will probably be mixed — including sorrow if your benefactor has died, deep gratitude for someone’s generosity, elation over the financial windfall, confusion about what to do with the assets you receive, and perhaps fear of the unknown burdens of such good fortune.
Once your emotional roller coaster comes to a stop, you should consider how to spend, allocate, and invest your funds in a way that fits into your (and your family’s) long-term values and goals. For most people, that means dealing with some or all of the following issues:
Normally an inheritance, a gift, or proceeds from a trust would not be considered taxable income. On the other hand, a distribution from a decedent’s IRA, 401(k) or other qualified pension plan is subject to income tax, and the calculations could get complicated. Lottery winnings may also result in income tax liability. To be sure, consult your professional tax preparer or financial adviser.
If you receive real estate, interest in a business, or other hard asset, you’ll have to decide whether it’s in your best interest to sell it or hold onto it. A vacation home, for example, is something you might want to keep in the family and make use of, or at least keep as an investment. On the other hand, if that property represents your only significant investment, you may want to sell it and diversity your holdings.
One advantage to selling inherited real estate that has appreciated in value is that you enjoy a step-up in basis, so you’ll pay no capital gains tax. (The same advantage does not apply to real estate that you receive as a gift.)
If you receive interest in a business, check to see if you are obligated by a buy-sell agreement to sell the interest back to the corporation or to the other partners.
Before you spend or invest the inherited funds, it’s usually a good idea to pay off your creditors, especially high-interest credit card debt. Retiring low-interest debt, such as a low-interest mortgage loan, isn’t always the best thing to do, so consult with your financial adviser.
When your net worth suddenly increases, one of your priorities should be to review – and possibly revise – your estate plan. This is especially important if your windfall places your net worth above the federal estate tax exclusion, which in 2008 is be $2 million. If you leapfrog past that exclusion amount, you’ll want to establish one or more trusts to hold assets outside of your estate for estate tax purposes (and to avoid probate).
Having a lot more money to work with might change your mind about who you want to include in your will, who to name as beneficiaries of your trusts, and possibly who to appoint as trustees. For a large estate, it is advisable to name an institutional trustee to manage diverse trust assets, especially if one or more beneficiaries are minor children, are disabled, or have special needs.
This is a great time to set aside funds for a child’s or grandchild’s future college tuition or other education expenses. Thanks to Section 529 of the U.S. tax code, most states have established tuition savings plans that let you deposit funds in a savings account and never pay tax on the interest as long as you use the funds to pay college tuition. (In most cases you would pay a penalty for withdrawing the funds for any other purpose.) Ask your financial adviser to refer you to the appropriate state agency to learn more.
If you inherit or receive a gift of cash, you’ll probably want to invest a sizeable portion of it in a diverse portfolio of stocks, bonds, and mutual funds (including some foreign securities) If your inheritance consists mostly of a single stock or narrow range of securities, you may want to sell some of it in order to diversify, even if you incur capital gains tax.
As you get older, you’ll want a higher percentage of bonds in your portfolio, to insure a steady income — especially if you are retired.
Some people take great pleasure in sharing their good fortune with family, friends, community organizations, and charities. If you care to devote a sizeable portion of your inheritance to charitable causes, you may want to establish a charitable remainder trust or donor-advised fund to take advantage of significant tax breaks.
If you’re so inclined, go ahead and treat yourself to a new kitchen, dream vacation, sailboat, power tools, or plastic surgery. Beware, though: In a small minority of cases, people who inherit lots of money have gotten carried away and binged on luxuries until the funds tragically evaporate. Make sure your discretionary spending is in line with your family’s needs and values.
For obvious reasons, many people — in the sales and financial services industries, for example — are keenly interested in knowing who inherits large sums of money. Some people — maybe even you neighbors — are just plain nosy, and tend to be jealous of those who suddenly become wealthy thanks to a windfall.
If you are the beneficiary of a trust, your bequest is a private matter, and there is no reason any outsider should know about it unless you tell them. But if your inheritance has been through the probate process, it is a matter of public record, and anyone can go down to the courthouse and read the file. To protect your privacy, and especially that of your children, consult your family lawyer or contact the Privacy Rights Clearinghouse in San Diego (619-298-3396).
For the vast majority of people, an inheritance or gift comes as a blessing. Unfortunately, for a few it can seem like a curse, bringing out the worst in them and their families. Fighting over inheritances is not uncommon. Nor is conflict between heirs, beneficiaries, executors, trustees, guardians, and relatives thereof. Not only is such conflict emotionally draining, but it can be costly as well, sometimes dissipating much of the inheritance.
In such a case, good lawyers and financial advisers aren’t enough. You need to consult a social worker, psychologist, or family services organization. Often the resolution of family conflicts is much more important and satisfying than the acquisition of large sums of money.
Alan G. Orlowsky, President of Orlowsky & Wilson, Ltd. in Lincolnshire, Illinois, has been counseling people on estate planning for 28 years. He previously worked for the IRS in its Estate and Gift Tax Division. He also worked for the Deloitte & Touche accounting firm, and he has taught taxation and accounting at Loyola University of Chicago, School of Business.
Al is a contributing author of the book 21st Century Wealth (Esperti Peterson Institute, Denver, 2000), and has written numerous articles on the subject of estate planning. Contact Alan Orlowsky by email or call 847-325-5559.