Inheriting a significant amount of money can provide financial security and open new opportunities. It also has potential tax implications that can eat away at your newfound wealth if not appropriately managed.
With careful planning and the right strategies, you can minimize the tax burden and maximize the value of your inheritance.
According to a survey of Consumer Finances by the Federal Reserve System (discussed here), approximately 20% of U.S. households received an inheritance at some point in 2022. That percentage doubles for those in their 70s.
According to Kiplinger, only 42% of those who expect to receive an inheritance feel comfortable handling their newfound wealth (which averages $740,000).
Let’s explore strategies to help you navigate tax complexities and preserve more of your inherited wealth. From estate planning to investment planning, we’ll cover a range of tactics to ensure you make the most of your windfall while staying compliant with tax laws.
Estate Planning and Trust Strategies
One of the most crucial steps in minimizing the tax burden on an inheritance is proper estate planning by the person leaving the inheritance. Strategies like creating trusts, gifting assets during your lifetime, and taking advantage of federal and state estate tax exemptions can significantly reduce your tax liability.
For example, by setting up an irrevocable trust, the assets placed within the trust are removed from your estate, potentially reducing the overall value subject to estate taxes. Trusts can also provide ongoing asset management and distribution control, ensuring your inheritance is handled according to your wishes.
Charitable Contributions and Gifting
Another effective strategy to reduce estate taxes is to consider making charitable contributions or gifting a portion of your inheritance to loved ones. This allows you to support causes or individuals you care about and can also provide valuable tax benefits.
Charitable contributions are generally tax-deductible, potentially offsetting a portion of your income tax liability. Furthermore, by gifting portions of your inheritance to family members or others, you can take advantage of the annual gift tax exclusion, which in 2024 allows you to give up to $18,000 per recipient without incurring any gift tax.
Investment Planning
Once you’ve received your inheritance, developing a sound investment plan is important for managing and growing your wealth. Working with a financial advisor who is also a certified public accountant, you can explore strategies that align with your risk tolerance, time horizon, and financial goals.
One approach is to diversify your assets across various investment vehicles, like stocks, bonds, and real estate. This can help mitigate risk and potentially generate higher returns over the long term. 1
Certain investments, like municipal bonds or tax-advantaged accounts (e.g., 401(k)s and IRAs), can provide tax-efficient growth opportunities.
Real Estate and Business Investments
Real estate and business ventures can be attractive options for those interested in more hands-on investments when inheriting a large sum. Investing in income-generating properties or starting a new business can provide potential returns and tax benefits through deductions for expenses, depreciation, and other write-offs.
Consulting with financial advisors, real estate attorneys, accountants, and business advisors can help you make informed decisions.
These professionals can provide guidance on the most appropriate strategies, help you navigate complex tax laws and regulations, and ensure that you’re taking advantage of all available opportunities to minimize your tax burden while preserving your inheritance’s value.
Case Study: The Prudent Inheritor 2
To illustrate the potential impact of implementing effective strategies, let’s consider a hypothetical case study. Imagine you’ve inherited $5 million from a distant relative. Without proper planning, this inheritance could be subject to significant estate and income taxes, potentially eroding a substantial portion of your windfall.
However, by working with a team of professionals, you implement the following strategies:
- Establish an irrevocable trust to hold a portion of the assets, removing them from your taxable estate.
- Make charitable contributions to organizations you support, providing tax deductions.
- Gift portions of the inheritance to your children and grandchildren, taking advantage of the annual gift tax exclusion.
- Invest a portion of the inheritance in a diversified portfolio of tax-efficient investments, like municipal bonds and tax-advantaged accounts.
- Explore real estate investments, leveraging the tax benefits of depreciation and other deductions.
Through this comprehensive approach, you’ve successfully minimized your tax liability, preserved a significant portion of your inheritance, and positioned yourself for long-term growth and financial security.
Final Thoughts
Inheriting a large sum of money can be a life-changing event but also comes with potential tax complexities. By understanding and implementing effective strategies, like estate planning, charitable giving, investment planning, and seeking professional guidance, you can minimize the tax burden and maximize the value of your inheritance.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk, including loss of principal. No strategy ensures success or protects against loss.
LPL Financial does not provide tax advice or services. Please consult your tax advisor regarding your specific situation.
Allied Integrated Wealth and LPL Financial do not provide legal advice or services. Please consult your legal advisor regarding your specific situation.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
This is a hypothetical example and is not representative of any specific investment. Your results may vary.