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Receiving an inheritance can be both a blessing and a challenge.
Inherited dollars generally have a different emotional attachment than earned dollars.
While these funds can provide significant financial opportunities, they often arrive during a difficult time, making it crucial to approach inheritance planning with both sensitivity and strategy.
The Danger of Inheritance Expectations
One of the biggest mistakes is building your financial future around an expected inheritance. This approach can be risky because:
- Inheritance amounts can change unexpectedly
- Timeline of receipt is often based whether the asset is considered part of the estate or passes by beneficiary
- Medical or other expenses of the individual leaving assets might reduce the inheritance
- Investment performance can impact the final amount
Understanding the Inheritance Timeline
The inheritance process isn’t always as straightforward as receiving a check.
Estate settlement typically takes several months—sometimes years—depending on various factors.
If assets are held in a trust, the process might move quickly. However, properties going through probate often face longer timelines and more complex legal procedures.
Assets that pass by beneficiary may proceed quicker, however, it’s important to make sure you are aware of the type of asset you are inheriting, specifically from a tax perspective.
Managing and Understanding Tax on Inherited Wealth
Understanding Federal Tax Implications
Different types of inherited assets carry different tax consequences:
- Traditional Inherited IRAs now follow the 10-year distribution rule for most non-spouse beneficiaries
- Roth Inherited IRAs also follow a 10-Year distribution rule, but if withdrawals are qualified, can be tax-free.
- Brokerage accounts benefit from a stepped-up cost basis
Difference Between Estate Tax and Inheritance Tax
At the federal level, there is a federal estate tax for estates that cross a certain threshold.
As of January 1st, 2025, that amount is $13,990,000 per person.
Be aware, this figure is subject to change, and the Tax Cuts and Jobs Act of 2017 is set to expire at the end of 2025 (assuming no action is taken before then), which could drastically cut the estate tax exemption.
There is no federal inheritance tax, which essentially means that a beneficiary would not be responsible to pay tax once it’s received.
However each state has their own state rules.
State Estate Tax
When an individual dies, his/her estate is typically opened. If the individual dies in a state which has an estate tax, the estate is responsible for paying that tax.
Therefore, beneficiaries should be aware that this amount would be paid before the beneficiary receives the funds or assets.
Much like the federal level, states have exemption levels.
State Inheritance Tax
For states that impose an inheritance tax, this is the responsibility of the beneficiary to pay the tax due.
For example, in Pennsylvania, depending on the type of beneficiary you are, you may have to pay a percentage to the state:
- Spousal Beneficiaries pay 0%
- Direct Lineal Descendants pay 4.5%
- Siblings pay 12%
- Other heirs pay 15% (except exempt charitable distributions or other entities exempt from tax)
You’ll see each state’s estate and inheritance tax rules as of 2024:
Creating Your Inheritance Action Plan
Step 1: Don’t Rely on This
It’s rarely a good idea to “rely” on an inheritance. Many things can change for the individual you expect to receive funds from, so you should not be making financial decisions surrounding this until you have received the funds.
Rather, you should continue to practice good habits within your own plan.
Step 2: Understand the Process
Do you know what type of asset you’ll be receiving? For example, if a parent is leaving you a home, the turnaround time of upkeep, cleaning the home, and eventually selling the home can take months (or longer).
If a parent is leaving you an investment account, you should gather documentation needed and understand the process of how this would transfer.
Step 3: Have a Tax Plan in Place
Having an understanding of how federal income & estate taxes will apply (if at all) to your assets is a good first step. From there, you should understand your state tax law, and the state tax law of the individual who died.
Generally, it’s a good idea to mentally account for tax due when receiving these funds.
Step 4: Spend, Save, or Give Accordingly
There is generally a grieving process that accompanies receiving an inheritance.
If the funds received are from a parent, we’ve worked with children who are unsure what to do with these funds from a psychological standpoint.
It could be the case you need to pay off revolving credit card debt, or keep the funds invested.
It may also be the case that you have a plan of what to do with these proceeds, or it could be the case you want to honor the individual you received the funds from.
In the event they don’t designate these funds to be used for a specific purpose, you should give thought to how you want to receive these funds and utilize them accordingly.
Preserving Your Own Legacy
Remember that an inheritance represents more than money – it’s often a loved one’s legacy. Making thoughtful, strategic decisions about these funds honors that legacy while securing your financial future.
But you should also make sure you have a plan in place for your own assets and how these will be distributed, as we never know when our time is up.