Your inheritance is the property you receive from someone upon their death. It can include cash, investment accounts, retirement accounts, real estate, life insurance policies, jewelry, cars, fine art, antiques, and other assets.
Understanding what an inheritance is and how it works can help you minimize any taxes you may owe. An inheritance refers to any assets a person leaves to someone else after they die. It could include property such as cash, investment accounts, retirement accounts, real estate, life insurance policies, jewelry, cars, and other valuables. When you receive an inheritance, you are considered the beneficiary. Someone can name more than one person to be a beneficiary of their property after they die.
For example, your mother may leave you her house, life insurance proceeds, and bank accounts to you as your inheritance in her will. She may leave her investment accounts and jewelry to your sibling, so that property would be their inheritance.
How an Inheritance Works
How an inheritance works depends on how assets are designated to be transferred. There are a few ways this can occur, including outside of probate, via a living trust, for example, or through probate. If there’s a will (and no living trust), it’s submitted to probate to start the distribution process. The probate court begins this process by authenticating the last will and testament and appointing the executor of the estate. The executor pays any debts and taxes owed by the deceased before distributing the remaining assets to their rightful beneficiaries. If a person dies without a valid will, or “died intestate,” their assets still go through the probate process. Their assets are divided up based on the state’s “intestate succession” laws instead of the deceased’s wishes. In most cases, assets go to their closest relatives.
Assets that are jointly owned, have a designated beneficiary, or are held in trust may not have to pass through probate, even if the deceased person did not have a will. For example, bank accounts with a payable-on-death beneficiary and life insurance policies with a named beneficiary pass directly to the recipient. Jointly-owned assets also go directly to the surviving co-owner. If you receive an inheritance, you should be aware of the tax laws that will apply. You could potentially pay various taxes on an inheritance, such a state inheritance tax. Surviving spouses are always exempt from inheritance taxes. In some states, children may also be exempt or face a lower tax rate. Beyond that, the amount of inheritance tax you pay depends on your relationship with the deceased and the state laws. Generally, the closer in relation you are to the deceased, the lower your tax rate.
For example, in Utah, you’re exempt from all inheritance taxes if you’re a surviving spouse, parent, child, grandchild, brother, or sister. You pay a 4%-16% inheritance tax (with a $1,000 exemption) if you’re a niece, nephew, aunt, uncle, great-grandchild, daughter-in-law, or son-in-law. All other people and organizations pay a 6%-16% tax (with a $500 exemption). In this example, the tax rate increases along with the size of the inheritance.
How to Leave an Inheritance to Your Grandchildren
As you plan for your estate, you’ll likely consider your children. But what if you’d also like to include grandchildren—even if they haven’t been born yet? Are there tax-efficient, considerate strategies for passing down your wealth and property without worrying about your hard-won funds being spent on frivolous items? We all want to be remembered, and an inheritance creates another connection to your grandchildren, whether you’re giving money and a head start, or a prized collection of baseball cards. To provide your grandchildren with an inheritance, consider how you want to create those memories and plan your inheritance carefully.
• If your estate exceeds federal estate tax exemptions or incurs state inheritance or estate taxes, an estate planning lawyer or tax professional can help you set up the inheritances in the most tax-efficient way.
• Various vehicles exist to leave an inheritance to grandchildren, including trusts, wills, custodial accounts, and account transfers. Choosing from these methods may require the expertise of an estate attorney.
• Prepare your grandchildren for their inheritance by discussing your plans, setting expectations, and asking for input.
What to Consider With Inheritances
One of the central issues for any inheritance is whether your estate could exceed the federal estate tax exclusions or be subject to state estate taxes. As of 2021, the federal estate tax exclusion for your total estate is $11.7 million per person. The exclusion increases to $12.06 million in 2022. It’s important to know that the exclusion amount may be temporary because it was set by the 2017 Tax Cuts and Job Act and could revert to the previous limit of $5 million, adjusted for inflation, in 2026. New federal legislation could also lower the estate tax exclusion at any time. If the total gifts you give during your lifetime and your estate together are less than $11.7 million ($12.06 million in 2022) before 2026 are not subject to state estate taxes, minimizing estate taxes won’t be your central concern. However, you’ll still need to ensure you’ve left clear legal instructions on assets and gifts intended for your grandchildren. If your estate is more than $11.7 million ($12.06 million in 2022), not only will estate taxes be levied, but direct estate gifts to grandchildren may incur the generation-skipping transfer tax, another whopping 40% in taxes.
Some states also charge estate and inheritance taxes for grandchildren who receive estate assets, no matter the estate’s size.
For example, Utah charges a 4.5% tax on assets received by direct descendants and lineal heirs. Some states, such as Iowa, base inheritance taxes on the share of the estate or right to receive the amount and the recipient is responsible for the taxes although property passed to a surviving spouse and lineal descendants, including children and grandchildren, is exempt.
In other states, such as New Jersey, grandchildren may face an inheritance tax for amounts larger than $675,000. Due to these differences, consulting with an estate lawyer in your state is critical.
The Best Ways to Leave Money to Grandchildren
The best way to leave money to your grandchildren depends on your circumstances and the size of your estate. There are a few different ways to go about leaving an inheritance to grandchildren.
A will identifies the grandchildren you’re leaving assets to and your intended distribution of those assets. A will can be the instrument you use to divvy up your baseball-card collection or jewelry among grandchildren. However, a will alone doesn’t always provide for a trust’s specific financial instructions, probate avoidance, and taxes. Also, you may not be able to pass some property to minor grandchildren through a will alone and will need to consult with a lawyer for the proper strategy. Within a will, a lawyer can create a simple trust.
You’ll appoint a trustee to hold and manage your grandchild’s estate portion that you want to protect in trust when you pass away. The trustee ensures that funds are used by the grandchild or for the grandchild’s benefit as intended. If you don’t create a trust, any funds you leave to your grandchildren are overseen by the child’s parents or guardians until they turn 18 or adulthood (per state), then given to the child.
A trust distributes your assets after you pass away while allowing you to have more control over how funds are used. For example, you can set up a trust that distributes your gifts over a period of years or as the grandchild ages (for example, portioning out a gift at ages 20, 25, and 28), or for specific purposes (education, a wedding, a first house). There are various ways a trust can be set up, including irrevocable trusts and revocable trusts.
However, a trust is only as good as the lawyer (and possibly, tax advisor) who drafted the trust. State law can impact how trusts function and how taxes are collected on them even if some grandchildren live in other states. A trust can be expensive to set up, so if you’re leaving a smaller amount (say, a few thousand dollars) to heirs, you may want to consider another approach.
A Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account allows a grandparent to give stocks, bonds, and other securities to grandchildren. The account also acts as the custodian of those funds until the child becomes an adult, according to individual state law. However, the grandchild can take possession of the gifts within these custodial accounts as soon as allowed by state law, and you have no control over how the funds are used. These accounts are subject to taxes on capital gains, interest, and dividends.
Investment, Retirement, and Bank Account Transfers
Bank and investment accounts can be transferred to a grandchild upon your death. They are a simple solution if you don’t need to divide a complex estate among grandchildren or only plan to gift a smaller amount. You can also leave the contents of your IRA or other retirement accounts to a grandchild, although doing so could result in estate taxes and depend on the tax laws in your state. A transfer on death plan can override a will, trust, or other estate planning vehicles. Establishing a beneficiary is often as easy as filling out an online form where you’ll name each grandchild and apportion percentages of the account. Even if you’re planning to leave funds to children, it’s also possible to designate the distribution method as “per stirpes.”
Per stirpes is the legal term indicating that you want your assets to pass equally to each branch of your descendants.
Educational Savings Accounts and Retirement Plans
These college savings accounts in a grandchild’s name allow grandparents to gift college-earmarked funds before death that grow tax-deferred in investments. Grandchildren can withdraw funds tax-free as long as they use the contents for higher-education purposes. Two popular accounts types are 529 plans: a prepaid tuition plan and an education savings plan, both run by state agencies. Coverdell savings accounts are another vehicle, although not as popular. You can boost a grandchild’s future golden years by establishing a retirement plan in their name. For example, as long as a grandchild has earned some income in the year, you may be able to contribute to their Roth IRA, which offers tax-free withdrawals at age 59 ½ or if they experience a disability. Remember that gifts to your grandchild’s accounts during your lifetime are subject to state gift taxes. They are also added to your total $11.7 million ($12.06 million in 2022) lifetime exclusion which includes your estate.
Preparing Your Grandchildren for Their Inheritance
The element of surprise isn’t ideal when it comes to inheritances, the last legacy you want to leave behind is a broken family by creating resentment due to improper planning; for example, leaving one grandchild the successful family business because they expressed a passing interest and leaving cash to another grandchild. After your passing, one grandchild might acknowledge they aren’t interested in business ownership, and the other grandchild feels shorted by cash versus a long-term investment that makes millions over decades. Furthermore, grandchildren and your children (their parents) may argue over the inheritance.
Call a meeting to discuss your plans even if your family doesn’t usually talk about money—to share your goals and ask for ideas. Describe how you’d like any money to be used, whether for college, a first home, or a future wedding. Most grandparents don’t want to see hard-earned cash spent on a sports car or European vacation. Even if you plan to leave a smaller amount or only contribute to an educational account, make your intentions clear; for example, perhaps you expect a grandchild to achieve a certain grade point average (GPA) in high school, use the funds for graduate school, or finish college in a certain amount of time. You’ll also want to discuss any potential tax implications or ask your grandchildren to consult with a tax advisor.
For example, your grandchildren may owe capital gains tax upon selling investments transferred into their name, or need to file tax waivers or fill out paperwork to benefit from a stepped-up tax basis for certain inherited account types.
If you’re hoping to care for your lineage through an inheritance, consult with a professional who can help you assess your circumstances and estate. But don’t forget to consider your grandchild’s needs and desires as part of the process. Help them understand your intentions when you leave them cash, stocks, property, or other assets. A thoughtful and transparent plan will help you avoid post-mortem conflict, confusion, and stress among the people you are trying to help.
Individuals who are considering drafting a trust or a will may wish to consult with an estate planning lawyer. He or she can explain the advantages of using a trust as well as a will. He or she can make recommendations based on the specific considerations of the client. He or she may even recommend using both documents, such as by using a pour-over will that places any property owned at the time of the testator’s death into the trust.