Inheritance Planning Considerations

Planning for inheritances is often neglected, with disastrous results. If an IRA is inherited and transferred directly to the heir’s regular banking account, the inheritance is treated as a distribution and the asset is taxed as income. This situation and others like it can be avoided with inheritance planning.

How is Inheritance Planning Different than Estate Planning?

Estate planning protects people and assets during life, while providing instructions for property distribution after death. Estate planning documents include a last will and testament to name an executor, a guardian for any minor children, and distribute the estate, a power of attorney to appoint someone to make legal and financial decisions and an advance health care directive to address medical care and end-of-life decisions.

Inheritance planning focuses on how assets will be received, with the twin goals of minimizing the financial burden on heirs from the inheritance and ensuring a smooth transfer of wealth.

For example, if an estate includes real estate, inheritance planning addresses how to minimize costs like property maintenance, real estate taxes, utilities, mortgage payments (if any), insurance and capital gains taxes, if the property is to be sold.

Trusts and Beneficiary Designations

Trusts establish a high level of control over inheritance, minimize taxes and allow wealth to be passed directly to beneficiaries without going through probate. Trusts are customized to serve many different purposes. They can control when assets are distributed and what they are used for and may require the recipient to achieve specific benchmarks. Assets are under the discretion of the trustee and not the heir.

Any asset with a beneficiary designation should be checked regularly. Beneficiary designations supersede instructions in the last will and can derail an estate plan if not updated. Failing to check beneficiary designations on life insurance policies, retirement plans and bank and investment accounts is a critical and common error.

Can an Inheritance Plan minimize Taxes?

Depending on the state, heirs may face federal and state estate taxes and inheritance taxes. As of this writing, few Americans need to plan for federal estate taxes. However, state estate tax exemptions are lower than federal exemptions. Six states still have inheritance taxes, and Maryland has both a state estate tax and an inheritance tax. Inheritance tax amounts are generally based on the person’s relationship to the deceased.

There are many ways to minimize taxes. For instance, it may make sense to convert some or all of an IRA to a Roth IRA, so taxes are paid by the account owner, rather than the beneficiary. Annual gifting while living, trusts, 529 contributions and taking advantage of the current gift tax exclusion should also be considered.

Ensuring Liquidity for Heirs

If heirs are likely to need cash to pay taxes or maintain a home, inheritance planning needs to address liquidity. A review of the estate plan and assets should be done to reveal how much ready cash will be required. Heirs often must sell valuable assets to meet the estate costs, undoing the legacy’s goals.

Inheritance Planning and Estate Planning

Inheritance planning strategies with an eye to legal documents, tax implications and fiduciary responsibilities put a finishing note on an estate plan, protecting assets and heirs.

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