When someone dies and there is no living spouse, survivors receive the estate through inheritance. This is usually a cash endowment given to children or grandchildren, but an inheritance may also include assets like stocks and real estate. Asset distribution is determined during the estate planning process, when wills are written and heirs or beneficiaries are designated.
The will specifies who will receive what. To distribute everything evenly, one can simply list beneficiaries. If certain items are to be left to certain people, that must be spelled out in the will. For the inheritance process to begin, a will must be submitted to probate. The probate court reviews the will, authorizes an executor and legally transfers assets to beneficiaries as outlined. Before the transfer, the executor will settle any of the deceased’s remaining debts.
How Inheritance Works When There Isn’t a Will
Inheritance becomes more complicated if the deceased did not outline asset distribution before death. In that case, a probate court must determine the wishes of the deceased as best it can. The probate court will check to see if the deceased named beneficiaries on stocks, bank accounts, brokerage accounts and retirement plans. Real estate, jewelry, heirlooms and other property can be more difficult to allocate. Once the plan is established, the court will appoint an administrator to act as executor and disseminate the assets. This process can take months or years to settle.
When an Inheritance Has Restrictions
If you are on the receiving end of an inheritance, be sure to read the fine print. The will writer can specify that you’ll receive payments in small installments rather than in one large sum. He or she can also restrict the inheritance to certain uses, like education. Depending on the terms of the will, you may only receive the money when you reach a certain age or a milestone, like college graduation or marriage.
Are Heirs Responsible for the Debts of the Estate?
Though creditors may attempt to collect debts from the deceased’s family members, they are not directly responsible for them. The executor of the will or the administrator pays any estate debts before distributing what remains of the estate. So as an heir, you aren’t personally responsible for those debts and you should point creditors toward the estate.
Where Are Inheritance Taxes Levied?
While there is no federal inheritance tax, six states impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. In all of these states, a spouse is exempt from paying inheritance tax. Children and grandchildren are exempt from inheritance tax in each of the states except for Pennsylvania and Nebraska. Exemptions vary by state for siblings, aunts, uncles and sons-in-law and daughters-in-law. You will likely face higher inheritance tax rates if you aren’t related to the deceased.
Where there is an inheritance tax, the tax rate depends on such factors as the state, your relationship to the deceased and the amount you inherited. Rates across all states range from 0% up to 18% of the value of the inheritance.
Inheritance tax is often discussed in relation to estate tax. However, these are two distinct taxes. The beneficiary pays inheritance taxes, while the federal government and 12 states, plus the District of Columbia, levy estate taxes on the estate of the decedent. Assets may be subject to both estate and inheritance taxes, neither of the taxes or just one of them.
Maryland is the only state that collects both estate and inheritance taxes. So residents of Maryland may encounter both taxes during the probate process. Of course, state laws change regularly. That makes it incredibly important to double check with your state tax agency and an estate planning attorney.
Inherited lump sums don’t fall under the definition of “income.” However, you could pay taxes on assets that create income. If you inherit stocks, real estate or other items that appreciate, you may have to pay capital gains tax once you sell them. The amount you’ll pay in capital gains tax is based largely on the amount of profit you make, using the value at the time of inheritance as your cost basis. If you inherit a retirement account, you’ll have to pay income taxes on distributions. Inherited Roth IRAs, however, are tax free, as are life insurance proceeds.
How Does Inheritance Work?
An inheritance describes the assets you’d like to leave to a loved one, who is in this case called a beneficiary. If you’d like, you can have multiple beneficiaries. The way an inheritance works will differ based on whether or not you’ve created a Will that clearly defines what assets you’d like to gift, and to whom.
In the first scenario, let’s pretend that you passed away, and you didn’t create a Will. Perhaps you verbally promised your house to a relative, and your cash assets to another. In this case, your estate becomes intestate. This means that all of your assets will be combed through in detail through a painstaking process called probate. Each state has different intestate laws, but generally, your assets might be divided up in a way that you didn’t wish for. Refer to our guide on what happens to your money if you die without a will for more information.
You might have guessed it already, but the second scenario is preferable. In this scenario, you had set up your estate plan and a detailed Will. In the case that you pass away, your assets will not have to go through probate, and will be allocated to your beneficiaries per your instructions.
How Do You Receive Money from a Will?
Let’s continue on with the example from earlier and pretend that your grandmother recently passed away. Your grandmother told you verbally that she named you her beneficiary in her Will. You’re probably wondering what the actual process of receiving money from the Will looks like.
In her Will, your grandmother would have named an Executor. This individual is responsible for making sure that the wishes in your grandmother’s Will are carried out dutifully. Executors are commonly attorneys or trusted family members. There are several steps they must follow before they can give you your inheritance.
Step 1: Asset Inventory
The Executor’s first task is to obtain your grandmother’s estate planning documents, including the Will, along with other important documents. Bank statements, house deeds, car titles, and insurance policies are all examples of documents that must corroborate what was delineated in the Will. Any outstanding bills must also be collected. The Executor may be required to present this information to a probate court, depending on the state.
Step 2: Asset Valuation
Next up, the value of your grandmother’s assets must be calculated. The courts require a listing of all assets in the inheritance, as well as their date-of-death value. If you as the beneficiary decide to sell any of the assets, you’ll be assessed capital gains tax. Although taxes are unavoidable, getting the date-of-death valuation is a good thing. It’s called step-up in basis, meaning that you’re only going to be taxed on the gains you made from the date-of-death value, and not from the prices at the time the assets were originally acquired.
Step 3: Bill Pay
If your grandmother had any outstanding bills, they must be resolved before you can receive your inheritance. Here’s a list of common types of bills that are often outstanding upon a person’s passing:
The Executor is responsible for notifying creditors of the death. Oftentimes, a notice will be placed in a newspaper, along with instructions on how to report a claim within a set time limit. Any disputed claims could go before a judge, which can complicate things and extend the timeline.
Step 4: Taxes & Returns
In the second to final step, the Executor will then file any required federal and state estate taxes, inheritance taxes, and final income taxes on behalf of your grandmother. Any taxes owed must be paid at this time.
Step 5: Distribution
Finally, it’s time for the inheritance to be distributed to the beneficiaries. Distribution of the inheritance is the last step because all bills and taxes must be paid. As the beneficiary, you don’t want to be held liable for any unpaid bills or deal with legal battles.
What Happens When You Get an Inheritance?
The Executor must submit the Will and other important documents to the probate court, and then pay any outstanding bills and taxes. Once that’s done, you can expect to receive a disbursement of financial assets and transfer of ownership of any tangible assets. The Executor will follow the instructions included in the Will to make this happen. As you might imagine, this process can take several weeks to months. Many states assess an inheritance tax. That means that you, as the beneficiary, will have to pay taxes when you receive an inheritance. How much you’ll be assessed depends on the state you live in, the size of your inheritance, the types of assets included, and your relationship with the deceased.
What Should You Do if You Inherit Money?
Coming across a windfall doesn’t guarantee you security. Some beneficiaries even end up worse-for-wear, after making irrational decisions and lifestyle changes after receiving an inheritance. What you do with your inheritance is a completely personal decision, but in general, there are some ways you can be smarter with your money.
First, consider working with a financial advisor. These are financial professionals who are trained to help you create a financial plan. They will likely have tips on how to pay off your debts, and how to invest your inheritance to grow your wealth safely.
Second, do your best not to spend all of your inheritance. This can be an emotional time, and you may not be thinking clearly. Instead, set your inheritance money way in a savings account, and revisit it at a later time when you can be more logical.
Finally, spend some time prioritizing your financial goals. Do you have debts you can pay off? Are you behind in saving up for retirement? Do you want to put more toward your child’s college savings account? Your inheritance could be a great way to catch up and get ahead, if you use it wisely.
How to Set Up Your Inheritance
On the opposite end of receiving an inheritance, there may come a time when you want to pay it forward and set up an inheritance for one or more loved ones. This can be done by establishing an estate plan. Follow these simple steps to get started:
Before you do anything, you’ll need to assess exactly what you can include in your inheritance. It’s a worthwhile exercise to sit down with a notepad and write down everything you can think of. It could be your cash, your house and any other property, your car, jewelry, and any other belongings that would be of any monetary or sentimental value.
Once you have your list of assets to include in your inheritance, it’s time to create your Will. Although the Will can pertain to other important agenda items, this is where you can delineate the contents of your inheritance. You’ll list out what you would like to gift, how much, at what timing, and to whom.
Don’t forget to name your executor and beneficiaries in your Will. The executor is the individual who will be responsible for making sure your wishes are properly executed. Because of this, it’s recommended that you pick a trusted person who can remain impartial in case of any family disputes. Your beneficiary (or beneficiaries) will be the individuals receiving the inheritance that you set up. Be sure to be specific about who gets what, and how much, because any vagueness in your Will can cause confusion, or worse, disputes amongst family members.
If the total value of your assets amount to $160,000 or more, you may want to consider setting up a living trust. A trust is a fiduciary agreement that allows your assets to be managed by a third party that you appoint. That way, the Trustee can distribute your assets per your wishes from the Trust account. A living trust allows you to set it up and continue controlling the assets while you’re alive. It’s another added layer of protection. Learn more about this in our guide on Trusts and why you might want one.
An important part of sound estate planning is good document organization. First and foremost, always plan to perform a routine review of your estate planning documents. Make sure that only the most up-to-date version is accessible to prevent confusion, and shred outdated and thus invalid versions. Your system should also include any important documents that accompany your Will or Trust, such as bank statements, deeds or titles, or anything that will help prove the legitimacy and value of the items listed in your inheritance. Last but not least, include instructions for accessing a password manager that contains the login information for any online accounts and digital assets.
