Three Major Inheritance Blunders and How to Avoid Them

If you're the beneficiary of a large estate, you may find yourself suddenly wealthy. Even when expected, the diverse array of assets and the varying tax implications of each can be overwhelming. Much like mountain climbers who plan to summit Mount Everest, where having an experienced Sherpa (local guide) to lead the way can provide much needed assistance during the process, a financial advisor can help.

Only about 16% of people in the U.S. receive an inheritance above $68,000, and if you can imagine, those that do can make many missteps that can put them in a worse financial position than previously. According to the Federal Reserve, the average amount received in inheritance for a middle-income American is $183,000. (Source: Federal Reserve, "Survey of Consumer Finances," Oct. 24, 2014.)

Inheritance events usually only happen once to those fortunate enough to be the heir someone's estate. I believe careful prior planning to make the most of this rare occurrence should be a high priority.

I've seen first hand, those who wanted to make the most of a significant inheritance and hired financial professionals to help them design a financial road map (a financial plan) ahead of time. Then when the inheritance took place, they simply followed the recommended steps based on their unique goals and needs. This process can help to shape the trajectory of their lives and their kids' future for the better. On the other hand, I've also seen those who receive a large inheritance, and although having the best intentions, to begin with, end up spending all the money within a few short years. It's sad and painful to watch people go from possibly never having to save another penny toward retirement or their children's education then find themselves in a place where working forever is a likely scenario. The unintended consequence for their kids' college education plans could result in up to six-figures in student loans.

Here are the Three Major Inheritance Blunders:

1. Mental Accounting Bias

Mental Accounting is a behavioral economics concept in which an individual classifies money in different areas or ways acquired with different values. This bias can lead to irrational spending or investment behavior. An example of this is when an individual receives a tax refund and treats it as "found money" then goes out and blows it on discretionary purchases when, in reality, it's their money over withheld on taxes that the IRS has been holding interest free.

With inheritance, some individuals treat the windfall as "bonus money" and develop compulsive spending behavior. I've seen people decide to all of a sudden, quit their day job and become self-employed. They start a business (that they might have no business being in), which becomes a great excuse to spend more money, thinking of money plowed in as "an investment in their future." Even over time, the business may never becomes profitable and lines to begin to blur between what was the inheritance and what was their previously saved money. Before they know it, their new business may have eaten up the inheritance as well as the rest of their savings.

Concerning accounting bias with irrational investment behavior, some individuals put significant sums into investment ideas (typically unregulated) with hopes of a significant upside and have no regard for the idea's viability or risk they are taking in the first place. Would you invest in an Alpaca farm if you have zero experience raising farm animals? How about investing a huge sum into a start-up with no clear path towards profit from someone you met at a networking event? How about "investing" in an electric car for $30,000 for a $4,000 tax credit? These actions can lead you astray from what is truly aligned with the financial goals you and your family have for the long term. A clear Investment Policy Statement (IPS) should be developed with a thoughtful list of what investments are to be considered and which investments are to be excluded before an inheritance arrives. Otherwise, anything "shiny" and enticing could send you on a spending goose chase. Ask a trusted financial advisor to help create an IPS to put guardrails on and serve as a framework for the intentions of the inheritance proceeds.

2. Failing to Protect Yourself from those Coming out of the Woodwork

If you read stories about those who recently won the lottery, you will inevitability come across those in which the lotto winners were taken advantage of by scam artists, thieves, or family members. One significant difference concerning a well-planned inheritance, it doesn't necessarily have to be public record and out there to attract the wrong kind of attention. One benefit of a trust passing assets to heirs is the ability to avoid probate and keep the transaction private. Sometimes attracting the wrong kind of attention can simply be avoided by keeping the inheritance private from friends, colleagues, and even some relatives. Think about this: a successful business owner who decides to buy a brand-new red Ferrari and uses it as his daily driver. He lives in a relatively rural and mainly poor farming town. So needless to say, this car sticks out like a sore thumb. Outside of some affluent areas, this types of extravagant purchases can draw the wrong kind of attention.

One issue that typically arises with friends and family is their new willingness to share their financial troubles with you and asking to be bailed out for their poor decisions or situation they somehow found themselves. Relatives conveniently asking for financial help can be tough because lending or giving money can change the dynamics of the relationship, and repayment can be unlikely, especially without collateral. Did you know roughly 40% of co-signed loans end up being paid entirely by the co-signer? Those who can't be financed or bailed out elsewhere may be a sign that they are not responsible enough to financially take care of themselves if a large sum is given to them. 

Many of my clients have found success in using their financial advisor as the "bad guy" to help ensure their inheritance doesn't become a well to continually come back and fill up when their water bucket (your inheritance) runs out. Consider a client who has received an inheritance from his parents, and through financial planning with an advisor, determined it was just enough to be able to retire and stay retired with a high likelihood of success. The client's daughter finds out about the inheritance and starting purchasing unnecessary discretionary items such as a new car, hot tub, vacations she couldn't afford. Then she asked her father (the client) to pay off her newly financed purchases as if she was entitled to the inheritance. We determine that paying these off could affect their ability to stay retired and their long-term financial security. I would explain to a client that this also sets up financial dependence, not financial independence.  Then I might suggest sharing with the daughter that "my financial advisor said we should not lend out money at this time to ensure we don't have to move in with you someday." It might sound funny, but I think the statement would stop the daughter from asking for handouts right away.

To avoid WW3, when an estate distribution takes place, if possible, have an independent fiduciary hired. This professional is usually a CPA or estate attorney whose job is to account for all the estate assets and help equitably distribute them. An independent fiduciary can be especially important when beneficiaries of an estate are siblings or other family members. I've run across circumstances where one sibling is the executor of their parent's estate (being in charge of the asset distribution). When their parents passed away, everything was originally planned to be divided equally among multiple siblings; but sometimes significant sums of assets go "missing." Sometimes one sibling finds out that the will or trust was changed shortly before their parent died, leaving them out of the inheritance. A family member attempting to cut another out of inheritance may sound ridiculous, but I have seen this similar estate battle unfold many times.

3. Misunderstanding the Tax Consequences and Rules behind Assets Inherited

It makes me cringe when I witness individuals making significant financial decisions based on emotion, not logic, and ending up giving a large percentage of inherited assets unnecessarily to the IRS or state revenue departments. If you are inheriting trust assets, be sure to learn about the rules in places (if any) for the distribution and use of assets. When making life-altering decisions, like quitting your job or making a significant purchase like a vacation home, finding out the trust assets cannot be used for your total income replacement or discretionary spending can put you in a tough situation.

The recent tax changes to inherited IRAs (under the SECURE Act) for non-spouses can have significant tax impacts depending on when and how you take distributions. In the past, a non-spouse beneficiary of an IRA could use the stretch provision to effectively stretch requirement distributions that come with inherited IRAs over one's lifetime (based on IRS RMD tables). The stretch provision could spread the taxes on the distributions over a few decades, which could also potentially allow the money to grow to become a lifetime source of income for the beneficiary. Now the required (and taxable) distribution amount must be taken out within ten years, which effectively speeds up the tax payment to the United States Treasury. Some recent beneficiaries of these accounts have strategically planned to wait a few years, forgoing any distributions, and planning to take large distributions in the first few years of retirement while leaving all other retirement savings to grow. Effectively planning these potential tax impacts coupled should be a key consideration since pensions, social security income, previous tax deductions, and credits could be reduced or completely taken away.

Some states also have unique inheritance and death taxes, which can vary depending on the beneficiary's relationship to the decedent. Transfer taxes from those inheriting assets from other countries can also widely vary. In these situations, a well-versed estate attorney can be an invaluable resource in planning asset distribution.


Thoughts on Overcoming the Inheritance Blunders:

Find a “Financial Sherpa” you can trust. Have them create a comprehensive financial plan so you can brainstorm your future together to make educated decisions along the way. Even if you are (or your spouse) is a financial "know it all," getting a second set of eyes on your situation from someone who's seen the various kinds of outcomes in these sudden wealth events can likely bring insightful perspective. Ideally, find a financial advisor who can connect you to an independent team of key professionals. An estate attorney is vital to help with distributing assets, a CPA is essential to account for everything and advise on different tax consequences accurately, and a financial advisor is crucial to show you the long-term impact of financial decisions you are considering. With these professionals' help, informed and educated decisions can be determined to help make the best of an inheritance event.

If you or loved one may benefit from guidance regarding inheritance planning, please submit in an inquiry below or use my scheduling link to book an introductory call:

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. The information is based on data gathered from what we believe are reliable sources. It is not guaranteed by Waddell & Reed, Inc. as to the accuracy and is not intended to be used as the basis for any investment decisions. Please consult your financial professionals before making financial decisions. (05/20)

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