The Nuances of Inheriting Money

Receiving an inheritance can stir up mixed emotions. While grieving the loss of a loved one, the beneficiary may realize the inheritance can provide financial breathing room or make life more comfortable. But coping with grief can make financial decisions harder. There also can be complex issues of using the funds to honor a loved one’s wishes and decisions on how to minimize any taxes.

How the inheritance process works

When a person passes away, their assets are transferred to others. The assets can include their personal belongings, cash, bank accounts, retirement accounts, and real estate. Recipients can be anyone including family members, friends, or charities. Some assets, such as retirement accounts and bank accounts, usually require that beneficiaries be designated for the asset to be transferred. The path to transfer of other assets may be less clear.

Generally, if the person died holding a certain value of assets, a probate case is started to determine or verify ownership. Probate is a court process when the assets of the deceased are distributed to the heirs. What it entails depends on how an estate’s assets are arranged before death, if there is a will, and state legal requirements. It can be costly and complex, so an estate planning attorney may be a helpful resource in figuring out the process.

An executor of the estate is appointed to oversee the probate process, from collecting all assets and ensuring all debts are paid to notifying heirs and distributing the inheritance before a final accounting.  One of the executor’s first duties is to set up an estate account, a special bank account used to disburse all funds. They are also ultimately in charge of transferring the assets to the beneficiaries. This person can be a family member, although that’s not a requirement. More than one person may share this responsibility, if preferred. They can be appointed by the court or named in the decedent’s will. 

Inheriting with and without a will

A will is an estate planning document that spells out how a person wants their assets divided upon their death. The people or entities named in the will to receive the assets are the beneficiaries. Beneficiaries do not have to do anything different whether there is a will or not, but receiving an inheritance can be a more difficult process and take longer without one.

With a will 

When a person dies and there is a will, it’s called testate. Family members may have an attorney begin a probate case to probate the will. The probate process begins with naming an executor, taking care of debts, and then, distributing assets. The will may name the executor, known as the personal representative in some states. Once the court names the executor, that person can begin managing the estate (sometimes with the assistance of a lawyer). First, the estate assets pay any outstanding debts of the deceased, then the remaining assets will be distributed. 

Receiving an inheritance as a named beneficiary in a will is a simpler process than if a person is an heir of a family member without a will. However, the probate process with a will can still take six to nine months.  

Without a will 

If a person dies without a will, or intestate, the probate process is longer and can be more difficult and complicated. In some cases, it can take years to complete. Each state has its own laws regarding property distribution when a person dies without a will. If the heirs contest the distribution laid out by state law, it will be up to the court to determine the distribution. Assets that had a payable upon death, sometimes also called transfer on death, designation are not included in the probate process and can automatically transfer to the named beneficiary. Common assets with this option include banking and individual retirement accounts (IRAs), and in some cases, vehicle registrations.

The court will designate an executor of the estate based on the state’s laws, often a spouse or an adult child of the deceased. The executor will be in charge of determining the beneficiaries and distributing any remaining assets. Without a will, the spouse is commonly first in the line for an inheritance, followed by any shared children. If there are any children from a different relationship, they could receive a portion of the estate as well; however, state laws vary on how assets are divided.

Restrictions an individual may encounter when inheriting money

Planning to pay off credit cards or have travel plans after receiving an inheritance? Not so fast. There can be potential restrictions on the use of an inheritance or even the timeline for the distribution. It’s important for a beneficiary to be aware of restrictions attached to the asset before making plans on using the funds to avoid making any financial mistakes.   

• Rules in the will.

   In a will, a person can impose limitations on an inheritance. This can include preventing a beneficiary from using the funds immediately or how they would like. For example, a will can contain a clause that funds are for educational purposes only, limiting the person to use the inheritance for tuition or school expenses. Or, the beneficiary may not receive the inheritance until reaching a certain age or at different intervals in life, such as graduation or marriage. 

• Asset rules.

  Not only may there be potential restrictions in a will, but even without a will, there can be rules to follow based on the inherited asset type. If a person is a beneficiary on a retirement account, for example, they may receive the account automatically. But inheriting a retirement account comes with rules about withdrawing funds. Some accounts, like a 401(k), may require the individual inheriting the account to deplete the funds within 10 years. But if the beneficiary is the deceased’s spouse, they may be able to keep the retirement account as their own.   

What taxes are applied? 

Inheriting money can require the beneficiary to pay some taxes and the estate to pay others. Depending on the estate’s location, certain state taxes may apply. 

• Estate tax.

  The federal government levies taxes on estates valued at more than $12,060,000 as of 2022. These taxes are deducted from the estate’s assets, and the remaining funds are distributed to beneficiaries. 

• Inheritance tax.

  Some states impose an inheritance tax, which would require the beneficiary to pay taxes on the assets received. There are exemptions for spouses and immediate relatives inheriting assets to eliminate the tax burden for close relatives.   

• Income taxes.

  Income taxes may be the most common tax a beneficiary pays. Although the asset itself may not be taxed, taxes are due on any interest earned since the interest is considered income. 

Income taxes may also be due if a beneficiary withdraws funds from an inherited  tax-advantaged retirement account, such as a 401(k). Generally, distributions from an inherited Roth IRA are not taxed, as long as the five-year rule for tax-free withdrawals is met. The beneficiary would pay ordinary income taxes on the amount withdrawn, just like the deceased would have had to pay on a withdrawal. 

Selling an asset could also trigger taxes. If a beneficiary holds onto and later sells an inherited asset, such as securities or a home, a beneficiary may end up owing capital gains taxes on any gain. For example, if a stock is inherited and is worth $100 at the time of the person’s death, then is sold by the beneficiary for $120, the beneficiary would owe taxes on the $20 gain. 

The bottom line

Inheriting money may help ease financial burdens, but it can be difficult to know how to manage an inheritance while experiencing grief. The legal process of overseeing a deceased person’s estate is known as probate, and navigating it can be challenging. But understanding  the rules and restrictions of inherited money, real estate, and other assets and being aware of potential tax consequences can help a beneficiary better manage any inheritance.  

It can take months—even years— to receive an inheritance after someone dies without a will. Even with a will, a person may encounter restrictions on how they can use an inheritance, such as only for education expenses or to buy a home. These limitations may be written into the will or specifically tied to the asset. And in some cases, receiving an inheritance may require the beneficiary to pay additional taxes.