How To Use Your Inheritance to Cushion Retirement
Baby boomers are poised to inherit the largest-ever sum of “inter-generational wealth.” And with retirement becoming more and more of a luxury, they’ll need it.
By Bettijane Levine 08/01/2011
If you’re a boomer, you don’t need a psychic hotline to learn you will likely inherit money.
Recent studies show that boomers, born 1946 through 1964, will receive up to $11 trillion in “inter-generational wealth.” That’s a fancy term for money passed down from deceased parents to their children — and it’s one of many phrases financial gurus use to sugarcoat the fact that a generation of beloved parents is passing on and, in doing so, is leaving a huge windfall to their boomer children.
Now more than ever before, these inheritances are expected to enhance the retirement of a boomer generation whose financial horizons have become murky. The economic downturn and the dwindling returns on IRAs and 401(k)s, along with the deflated real estate market and the general iffiness of many careers and businesses that once seemed solid, have all combined to make boomers more dependent on inherited funds than their predecessors.
Think back: In the good old days, every successive generation did better financially than their parents’. Now the reverse is often true: Boomers’ grown kids are moving back home, unable to find well-paying jobs that even Ivy League credentials can’t secure for them. Across Arroyoland — even in the most elite zip codes — boomers are totalling up their elevated living costs and quietly cutting back on expenses. They’re draining their pools and letting go of their drivers and household staff in favor of keeping cash in their own pockets. And so it becomes more essential for this generation to concentrate on what — and even whether — they are going to inherit.
A recent study by The Center for Retirement Research at Boston College reveals that two-thirds of all boomer households will eventually receive inherited funds, in a wide range of amounts. The average inheritance will be about $300,000; among the wealthiest 10 percent of heirs-to-be, the average is projected to be $1.5 million. For the least lucky 10 percent, the estimated average is $27,000.
It’s a subject few boomers (or their elderly parents) want to talk about. It’s difficult to discuss plans for one’s own demise, and even more difficult for a son or daughter to ask about such things. And that’s part of the problem, money managers and financial planners say.
An informal survey of San Gabriel Valley advisers shows that distress has already begun to surface among local boomers who’ve started to receive inheritances and have no idea how to handle them. They look at it as “found money,” says one adviser. But it can be lost just as quickly if they don’t understand the legal ramifications and tax regulations. Even if the money is clear of restrictions, boomers tend to make too hasty decisions on how to spend it — decisions they often regret.
So what should an heir do first?
Answer: Nothing. Put the money in a separate account under your name only, even if you’re married. Do not remove or commingle the funds, and quickly consult a trusted estate attorney (or two). Time is of the essence in many situations. Depending on the form of the inheritance — an IRA, a 401(k), stocks, real estate, etc. — you need to know how to proceed without falling prey to the vagaries of the often obscure and complicated inheritance laws.
An inherited traditional IRA, for example, can cause huge tax problems if you don’t know the rules. Most important: You’re not really inheriting the full amount, because an inherited IRA is taxable income. Whatever you withdraw from the inherited IRA will be added to your regular income at tax time, and your taxes could soar. If you earn $80,000, and take the funds from an inherited $100,000 IRA, you will be taxed on earnings of $180,000. You may also be taxed on the full amount if you simply mishandle the transfer of the account.
To complicate matters more, IRS laws also state that you must start withdrawing money from an inherited IRA the year after the original account owner’s death. How much must you withdraw? The answer varies with each individual. Factors include the ages of both the deceased and the heir as well as various technicalities surrounding your handling of the account.
An IRA that you recast as an “inherited IRA,” for example, may allow you to withdraw smaller amounts each year, which will lessen your annual tax bite. So no matter how eager you are to enjoy your windfall, do nothing until you’ve consulted your financial adviser.
All sorts of other problems are surfacing, experts say, many of which could be prevented if families would just speak plainly amongst themselves before a parent’s death occurs. While one or both parents are alive, offspring should discuss financial plans with them. “You’d be amazed at how many older people think they have proper plans in place, but really don’t,” says Larry Russell, a Pasadena financial planner. “Many people have wills but not living trusts. Without a living trust, assets above $100,000 can go into probate.”
Even wealthy individuals who do have trusts and employ financial advisers often neglect to tell their advisers to update their documents, Russell adds. “People’s lives change, but the beneficiary designations they’ve set up can sit there forever without review. They simply forget.” And few people have any idea how complicated inheritance regulations can be.
In a recent case, Russell says, a client and his wife intended to pass his hefty 401(k) on to their only daughter. The wife died, the man remarried and the 401(k) was still in place. That proved disastrous for his child. Had the man moved his 401(k) into an IRA, the daughter would have inherited the money that was intended for her, Russell says. But because he left his funds in a 401(k), “the beneficiary designation did not dominate. The money intended for his daughter all went to his second wife instead.”
This is just one example of the many things that can go wrong, Russell adds. He agrees that it’s vital to plan beforehand, while the parent is still alive. And if you have siblings, bring them into the conversation, says Donna Chaney, a CPA and personal financial specialist in Glendale.
“Some of my boomer clients are receiving inheritances right now,” she says, and they’re not prepared. “They’re asking, what should they do? How should they invest? Their tendency is to invest too quickly, to put the money in products that restrict their use of the funds. I tell them, cash is okay. Keep it in cash until you know you’re making the right decision based on your life goals. They all want to start making money on their money, and sometimes that backfires.”
Chaney says some of her most interesting cases arise when multiple siblings inherit. “I recently had a case where two siblings were doing well financially and the third one was not, although all are doing good and meaningful work,” she says. Were the wealthy siblings willing to give part of their inheritance to the one who needed the money more?
“Absolutely not,” Chaney says. “All the old rivalries were still there — who got the pony when they were kids, who felt slighted by their parents for years? I had to act like a psychologist, trying to mediate and help them sort out what they might consider to be fair.”
Of course, the parents could have sorted all this out beforehand, if the kids had discussed it with them — or even if the parents had been more specific in their bequests. But that is rarely the case, Chaney says.
Mitchell Kauffman, a certified financial planner in Pasadena and Santa Barbara, says he has seen all these problems and many more. “The best we can do as parents is let our loved ones get on with their lives without being saddled with imprecise bequest directions,” he says. But all too frequently, he adds, cloudiness begets storms. “I’ve seen too many situations where it was not clear who got what in the will. They should have done a living trust, but they didn’t. And it ended up tragically.”
In one case, two parents died in a car accident, he says. “The husband was driving and he died first. The wife died later. They each had kids from separate marriages, and those kids all grew up together. But the children of the wife sued the children of the husband for wrongful death because the will was ambiguous as to how the estate should be divided. It was awful that these kids ended up fighting each other in court. Had the parents done a more specific and formal estate plan — perhaps a living trust — their wishes would have been more clear. It was a calamity. The kids spent much of their inheritance on legal fees.”
What’s lacking is consumer education, Kauffman says. Even people with relatively minimal assets should probably make a living trust plus a will in order to avoid probate. In California, only a member of the bar may provide estate planning advice and draft such documents. This means the living trust must be created by an attorney. And all documents should be reviewed every three to five years, to keep current with changes in tax laws as well as in people’s lives, Kauffman says.
If you are an inheritor, he adds, do research and consult professionals before you touch the money. “If you’re married, the first big issue is whether to keep the inheritance separate or commingle it with community property. The minute you commingle it with other funds, or use part of it for the wrong reason (such as paying household bills), it is considered community property. This is important, because even the best marriages can hit challenging times and may end in divorce,” he says. “And if parents gave that money to you trusting that it would continue down the lineage to their grandchildren, you should at least consider keeping it separate” in order to honor their wishes.
So the question remains: What’s the best way to spend your boomer inheritance, especially if you need it for a comfortable retirement?
Experts agree the answer depends on your financial situation before you inherited the money. If you have high debt, you may want to pay it off. If you have a mortgage, you might want to pay that off, too — although you would lose the tax deduction on interest. If you are wealthy — with a secure retirement plan, enough money to help your kids and a hefty emergency cash cushion — then go ahead and buy that Maserati or beach house you’ve always wanted. Stocks and bonds? Not one adviser suggested rushing out to invest.
This is, after all, a legacy from your parents — with all sorts of emotional implications. Maybe the best you can do is honor them by using it in a way you know would make them glad they left it to you.