Maximizing Your Inheritance: Smart Investment Strategies To Minimize Tax Burdens

If you've inherited a large sum of money, you may be eager to splurge. While it's okay to spend a portion of it on yourself, saving and investing for the future is the best option. There are numerous ways to invest an inheritance, and a financial advisor can provide valuable guidance.

One option is to contribute to an individual retirement account (IRA). Another is to max out your company retirement plan, such as a 401(k) or 403(b) account. You can also add to a health savings account (HSA), which offers tax advantages. Opening a brokerage account is another possibility, as it provides flexibility in adding or withdrawing money and investing in various financial instruments.

It's important to take a slow and measured approach when investing an inheritance. Evaluate your financial situation and prioritise how the inheritance is used. Paying off high-interest debt and building an emergency fund are generally good first steps.

Additionally, consider seeking professional financial advice, especially if you're unfamiliar with the process or overwhelmed by emotions. A fiduciary financial advisor can guide you through the tax implications and help create an investment strategy aligned with your goals.

Understand the tax implications of different assets

Understanding the tax implications of different assets is crucial when investing an inheritance. Here are some key points to consider:

Securities

If you inherit securities such as stocks, mutual funds, or other investments in a taxable account, you benefit from a "step-up" in the cost basis to the value on the day of the original owner's death. This means that if you sell the securities immediately, you won't owe any taxes. However, if you hold on to them, you'll only pay taxes on the difference between the sale price and the stepped-up value. It's important to notify the investment account custodian of the date of death to ensure you get this step-up.

Retirement Accounts

Retirement accounts like traditional IRAs or 401(k)s can be more complex. If you inherit one of these, you will likely have to pay taxes on the money. The rules differ depending on your relationship with the decedent and the type of account. Spouses usually have more favourable options, such as rolling the money into their own IRA and postponing distributions and taxes until they reach a certain age. Non-spouse heirs often have to withdraw all assets within a specified timeframe, and the rules can be intricate, so consulting a financial planner or tax professional is advisable.

Real Estate

When inheriting real estate, the value of the property is also stepped up to its value on the date of the owner's death. This can be advantageous if the property is in an area where real estate prices have increased significantly. However, selling a house can be complex and time-consuming, as you'll need to maintain the property, pay associated costs, and potentially deal with mortgage payments and taxes until it's sold.

Life Insurance

Life insurance proceeds are generally not taxable as income. However, the money may be included in your estate for federal or state estate tax calculations.

Tax-Deferred Accounts

Tax-deferred accounts, such as individual retirement accounts (IRAs) or employer-sponsored retirement plans, can be a strategic part of your financial plan. While gains in these accounts are generally protected from immediate taxation, they may be taxed at a later date when you make withdrawals. Consult a financial advisor to understand how to best utilise these accounts within your overall investment strategy.

Consult a financial advisor to navigate the process

Consulting a financial advisor can be an excellent way to navigate the process of investing an inheritance while minimising taxes. Here are some ways a financial advisor can help:

Create a Solid Financial Plan:

A financial advisor can assist in creating a comprehensive financial plan that aligns with your goals and priorities. They will help you strike a balance between short-term improvements and long-term objectives, ensuring your inheritance is well-utilised and not squandered.

Analyse the Makeup of Your Inheritance:

An inheritance may include various assets such as real estate, investments, cash, life insurance policies, collectibles, or even a family business. A financial advisor can help you understand the value of these assets and make informed decisions about spending, saving, or investing.

Address Short-Term Needs and Long-Term Goals:

Financial advisors can guide you in addressing immediate concerns, such as eliminating debt, while also helping you work towards your long-term aspirations. They can advise on strategies like investing for your children's education or exploring wealth management options like funding a family trust.

Navigate Tax Implications:

Understanding the tax implications of an inheritance is crucial. A financial advisor can help minimise your tax burden and avoid costly mistakes. They can guide you through inheritance tax laws, explain the tax consequences of selling investments, and provide strategies to reduce your overall tax liability.

Investment Management:

If your inheritance includes a portfolio of investments or taxable brokerage accounts, a financial advisor can help you decide whether to liquidate or retain those assets. They will consider your risk tolerance and long-term goals, selecting investments that align with your unique profile.

Retirement Account Guidance:

Inheriting retirement accounts, such as IRAs, come with complex tax rules and regulations. A financial advisor can help you navigate these rules, devise a withdrawal strategy to minimise taxes, and avoid potential IRS penalties.

Fee-Only Fiduciary Advisor:

When choosing a financial advisor, consider selecting a fee-only fiduciary advisor. These advisors offer unbiased advice, work in your best interest, and do not earn commissions from recommended investments. Their advice is impartial, and they can provide valuable guidance during emotional or challenging times.

Weigh up the pros and cons of selling inherited property

Weighing up the pros and cons of selling inherited property is a complex decision that depends on your personal circumstances, the property, and your goals. Here are some factors to consider:

Pros of Selling an Inherited Property:

• Liquidity: Selling the property provides instant access to a large sum of money, which can help cover funeral expenses, bills, or other financial needs.
• Ease of Maintenance: Inherited properties come with responsibilities. Selling the property relieves you of maintenance burdens, especially if it is located in a different state or city.
• Opportunity to Invest: The proceeds from the sale can be invested in other assets, such as stocks, bonds, or mutual funds, to grow your wealth over time.
• Avoid Capital Gains Taxes: Selling the property immediately at its fair market value can help avoid capital gains taxes. Additionally, if you live in the inherited property and make it your primary residence for a certain period before selling, you may be able to exclude a significant amount from capital gains taxes.
• Probate Avoidance: Quickly selling an inherited property can help avoid the complex and costly probate process, which is the legal procedure for handling a person's estate after their death.

Cons of Selling an Inherited Property:

• Capital Gains Taxes: Selling an inherited property may incur capital gains taxes, depending on factors such as the value of the property and how long you've owned it. Consulting a tax professional is essential to understand the tax implications.
• Emotional Attachment: Selling a property inherited from a loved one can be emotionally challenging, as it may hold sentimental value.
• Loss of Potential Income: If you planned to rent out the property, selling it means forfeiting the potential rental income.
• Cost of Selling: There are costs associated with selling a property, such as agent commissions, closing costs, and home improvements to get it market-ready. These expenses can reduce the overall profit from the sale.
• Missed Appreciation: Selling the property means you may miss out on potential future appreciation in its value.

Consider investing in stocks, bonds and funds

When investing a large sum of money, such as an inheritance, it is important to consider your current financial position, your goals, and how much time you are willing to dedicate to managing your investments.

Stocks, bonds, and funds are three broad categories of investments that can be used to diversify your portfolio and reduce your tax burden.

Stocks

Stocks are a type of security that represents ownership in a company. When you buy a stock, you become a shareholder and are entitled to a share of the company's profits. Stocks can be bought and sold on public exchanges, such as the New York Stock Exchange (NYSE) or the Nasdaq.

Bonds

Bonds are a type of fixed-income security, representing a loan made by an investor to a borrower, typically a corporation or government. The borrower uses the money raised by issuing bonds to finance projects or other expenses. In return, the borrower promises to repay the principal amount of the bond, plus interest, at specified intervals.

Funds

Funds, also known as mutual funds or exchange-traded funds (ETFs), are a type of investment vehicle that pools money from many investors to purchase a diversified portfolio of stocks, bonds, and other securities. Funds are managed by professional investment managers, who aim to generate returns for investors by investing in a variety of assets.

Tax Implications

When investing in stocks, bonds, and funds, it is important to consider the tax implications, as these investments can be taxed differently. Here are some key considerations:

• Taxable brokerage accounts: These accounts offer flexibility, as there are no restrictions on when you can withdraw your money. Investments held in these accounts for over a year are typically taxed at the long-term capital gains rate, which is more favourable than the short-term capital gains rate for investments held for a year or less.
• Tax-advantaged accounts: These include IRAs and 401(k)s, which provide tax benefits but have restrictions on withdrawals. Traditional IRAs and 401(k)s are tax-deferred, meaning you pay taxes when you withdraw the money in retirement. Roth IRAs and Roth 401(k)s are tax-exempt, as contributions are made with after-tax dollars, and withdrawals in retirement are tax-free.
• Municipal bonds: These are issued by governments and can reduce taxable investment income. The interest from municipal bonds is typically tax-free at the federal, state, and local levels, as long as the investor resides in the same state or municipality as the issuer.
• Corporate bonds: Unlike municipal bonds, corporate bonds are fully taxable at all levels. They also carry the highest level of default risk and pay the highest interest rates.

By investing in a combination of stocks, bonds, and funds, and considering the tax efficiency of each investment, you can work towards maximizing your returns while minimizing your tax burden.

Take advantage of tax-advantaged accounts

Tax-advantaged accounts are a great way to reduce your tax burden and maximise your returns. These accounts are designed to help people save for important goals like college, a mortgage, and retirement.

There are two main types of tax-advantaged accounts: tax-deferred and tax-exempt.

Tax-Deferred Accounts

Tax-deferred accounts allow you to contribute money from your earnings before it is taxed. The money, plus any interest accrued, is then taxed when you withdraw it. Traditional IRAs and 401(k) plans are common examples of tax-deferred accounts. These accounts provide an upfront tax break, as you may be able to deduct your contributions and pay taxes only when you withdraw the money in retirement.

Tax-Exempt Accounts

Tax-exempt accounts, on the other hand, accept contributions from your post-tax income, but you can withdraw and spend the money tax-free, subject to certain restrictions. Roth IRAs and Roth 401(k)s are examples of tax-exempt accounts. Contributions to these plans are made with after-tax dollars, so there is no immediate tax break. However, your investments grow tax-free, and qualified withdrawals in retirement are typically tax-free as well.

Choosing the Right Account

The right type of account for you depends on your financial situation and goals. If you expect to be in a higher tax bracket after retirement, a tax-exempt account like a Roth IRA may be a good option, as it offers the certainty of tax-free withdrawals. If you expect to be in a lower tax bracket in retirement, a tax-deferred account like a traditional IRA may be more advantageous, as it allows you to defer taxes until withdrawal.

Additionally, consider the level of flexibility you need. Tax-advantaged accounts often come with restrictions on when and how you can withdraw money. For example, you may face penalties and additional taxes if you withdraw funds from a 401(k) before the age of 59½.

By understanding the differences between tax-deferred and tax-exempt accounts, you can make informed decisions about how to invest your inheritance to minimise taxes and maximise your returns.

Frequently asked questions