SHOW NOTES: 2020-12-03 MiM

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Last Week’s Question of the Week: At what age can Americans move on to Medicare?

ANSWER: Age 65 is the earliest that Americans can move on to Medicare.

HOST: Today your topic revolves around inheriting money and the implications of it. What do we need to understand if this happens to us?

KLAAS FINANCIAL: When you learn that a loved one has passed away, it tends to be a very stressful and emotional time. And for many people there is also the reality that they may have inherited money and while we may be grateful, it can also bring its own share of stress.

The Federal Reserve Board’s Survey of Consumer Finances reports that an average of roughly 1.7 million households receive an inheritance each year. Of course, the amounts will vary to how much someone may inherit, but in 2018 the Survey of Consumer Finances (SCF) found that the median inheritance in the U.S.was $69,000. And an HSBC survey found that Americans currently in retirement expect to leave nearly $177,000 to their heirs. So today we want to offer some ideas of what to expect if this should happen to you, and initial tips to keep in mind.

Take time to grieve, and then look to understand the specifics of what you have inherited and the financial nuances associated with your inheritance.

Get an original or copy of the death certificate for each investment that you are the beneficiary of so when you file necessary paperwork you will have this document available.

Contact a financial professional to guide you. Your team may likely involve your financial advisor, your CPA, and perhaps an estate planning attorney. They will guide you and help you understand what is in front of you and how best to deal with the process in a methodical fashion.

HOST: What should people be careful of not doing?

KLAAS FINANCIAL: Resist the urge to spend it all at once. According to a study funded by the Bureau of Labor Statistics, one-third of people who receive an inheritance spend all of it, and even dip into other savings in the first two years.

So, do the opposite. Treat the inheritance as if it were your own money to start with. Remember that receiving an inheritance from someone should be a blessing, so properly managing how it can help you perhaps shore up your own debt, your own savings, or your future retirement vs. creating negative spending habits is very important from the beginning.

HOST: If I inherit money, will I have to have to pay taxes on that money?

KLAAS FINANCIAL: This is always the first question we hear. Generally, no. You may be pleasantly surprised to know that inheriting money from a friend or family member may not cost you a single dollar in federal income tax. Let’s look at the different tax scenarios:

  • Federal Estate Tax: The U.S. tax system may impose a tax on the decendent’s estate, which is the source of your inheritance money, if its value exceeds a certain amount. However, the value of the estate in 2020 would have to exceed $11.58 million per individual in 2020 for their estate to have federal taxes imposed. That means an individual can leave $11.58 million to heirs and pay no federal estate or gift tax, while a married couple will be able to shield $23.16 million. The annual gift exclusion amount remains the same at $15,000.
  • State Taxes: In this case, taxes on inheritances vary. As of 2020, the only U.S. states that collect an inheritance tax are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. So if you live here in Wisconsin or in Illinois you currently don’t have to worry about this. Each state sets its own inheritance tax rules, exemption amount, and rates. Most states use a progressive scale which means higher tax brackets for larger inheritances.
  • Income Taxes: Inheritances are not considered income for federal tax purposes, whether you inherit cash or life insurance or investments or property. 
  • However: Any subsequent earnings on the inherited assets are taxable, unless it comes from a tax-free source. You will have to include as income the interest from inherited cash in a bank account for example, or dividends on inherited stocks or mutual funds. And if you inherit property or assets that generate income that income is typically taxable to you.
  • Gains: The sale of inherited investments or property are generally taxable. (Long-Term Capital gains taxable)
  • Retirement Accounts: If you inherit certain retirement accounts, you will likely have to pay income taxes on distributions from inherited 401(k)s and IRAs, as you take distributions as the beneficiary. Remember, the person from whom you are inheriting this money from has never paid taxes on those earnings, and regardless who takes it out, somebody will almost always be paying income tax on it at some point.
  • Inheriting Annuities: Be careful. This is where you need to tread carefully. An annuity is an insurance product which often times wraps up the gains within the product. Upon inheriting these you may be in for a shock because the gains will actually be income taxable which could throw you into a completely different tax bracket. You do not get a stepped up basis whereas you may with the inheritance of a stock account.

HOST: What about inheriting retirement accounts? What is the process if I inherit a 401k or an IRA? Best first steps?

KLAAS FINANCIAL: You will likely need to open up a Beneficiary/Inherited IRA so that the money can be transferred into the new account to preserve its tax deferred status. Remember that any money in this type of account has never been taxed, therefore as the money comes out, you will have to pay income tax on it according to your own tax bracket.

New Changes in 2020: The passing one year ago of the SECURE Act (Setting Every Community Up for Retirement Enhancement) has changed several aspects of retirement accounts and plans. The law, which went into effect on Jan. 1, 2020, consists of 29 provisions that deal with several aspects of retirement savings plans and accounts including Required Minimum Distributions (RMDs) and inherited IRAs.

Key takeaways of the SECURE Act: It eliminated the ability to “stretch” your taxable distributions and related tax payments over your life expectancy if you are a non-spouse beneficiary. Said another way, if you’ve inherited an IRA on or after January 1, 2020, you must withdraw all assets from the inherited account within 10 years. There are 3 possible strategies to consider based on your situation:

1) Withdraw the assets as evenly as possible over the 10 years.
2) Wait until the end the of the 10-year period and then withdraw everything.
3) Make irregular withdrawals over the 10-year period.

HOST: What happens if I inherit a house with a mortgage? And what about other debts?

KLAAS FINANCIAL: If you inherit a house with a mortgage, then you also inherit the mortgage repayments. The bank has the right to request the payment of the loan in full from the beneficiary. Ideally, you will have enough assets to pay off the home so you can inherit it in full.

Once you are in contact with the mortgage servicer, you’ll need to decide what you want to do with the house. If there are multiple heirs or you aren’t the executor of the will, this could get complicated, especially if the people involved can’t come to an agreement.

One option is to simply sell the home to pay off the mortgage and distribute any leftover funds from the sale to the heirs as dictated by the will or the laws in your state. If you want to retain the home, you’ll need to work with the servicer to get the mortgage transferred to you.

HOST: Marcia from our Money in Motion Listener Corner asks: How long can I contribute to my retirement accounts?

KLAAS FINANCIAL: Great question! Under the new SECURE Act if you have earned income, there’s no age cap for contributing to a traditional IRA (previously you had to stop the year you turned age 70½) or into your retirement work plan. This change puts traditional IRAs on par with Roth IRAs, which never had an age cut-off.

However, contributions you make to a traditional IRA may or may not be deductible. The amount you can deduct may be limited if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels. If neither you nor a spouse are covered by an employer’s retirement plan, you can deduct the full amount. If you aren’t able to deduct contributions to a traditional IRA, contributing to a Roth may make more sense, assuming you fall under the income limits.

This Week’s Question of the Week: According to the Federal Reserve Board, in 2018, how many households receive an inheritance each year? Is it 500,000 or almost 2 million households?

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Catch C.J. Klaas and Maleeah Cuevas on Money in Motion every Thursday on Madison's 1310 WIBA from 8:05-8:35am.