An inheritance is an important estate planning tool. Whether you expect to receive one yourself or just want to ensure that your assets are properly distributed after you’re gone, there are numerous ways to protect an inheritance. (Not to mention, numerous things to protect an inheritance from, like taxes, divorce, or legal attacks.)
Keeping an inheritance safe isn’t a matter of luck. You need to proactively take the right steps in order to ensure that the wealth you’ve spent a lifetime accumulating isn’t torn apart by Uncle Sam or greedy family members. Unfortunately, it happens more often than you might think. Here are the most important things you need to know about protecting your inheritance.
Protecting an Inheritance From Taxes
First, some good news. Receiving an inheritance does not count as income, for the purposes of your federal income tax return. Unfortunately, the situation get a bit more complicated after that. Future earnings from that inherited assets are taxable. That means you could be on the hook for a large tax bill if an inherited house or investment portfolio continues to gain value. Even interest income counts, which could come from inherited cash sitting in a savings account or stock dividends.
One of the best ways to protect assets from being taxes heavily after a death is to create a family trust. This allows assets to pass from one family member to another without going through the probate process. Trusts can be both revocable or irrevocable, both in terms of which assets are included and who the trust members are.
Joint Assets
Some families try to solve the problem of inheritance taxes by putting assets, like a house, into a joint ownership with their heirs. This isn’t the same as creating a trust. Unfortunately, joint ownership can actually cause an even higher tax bill for the surviving family members.
When a joint owner passes away, the other owners already owns a portion of the asset. Common sense might make you think that means the surviving owners now own 100% of the asset. However, it doesn’t work like that. The portion that was owned by the deceased is still part of their estate. If the heirs want to sell the asset, they may end up with a large tax bill due to federal tax rules.
Protecting an Inheritance From Divorce
Unfortunately, divorces tend to be stressful and unpleasant. If one of the spouses had received a significant inheritance during the marriage, a divorce can cause things to get downright nasty. (In some cases, even a potential future inheritance can come up in divorce proceedings.)
The good news is that money and assets from an inheritance are not considered marital property. That means they wouldn’t normally be on the table during divorce negotiations of which partner gets which assets. The bad news, however, is that seemingly innocent decisions can change that fact in an instant.
For example, if you inherit some money from your parents and use it to buy a house for you and your spouse, it’s no longer an inheritance. It’s a marital asset in the form of real estate. Even something as simple as depositing an inheritance into a joint account, to help pay for marital expenses (rent, groceries, bills, etc) can cause some courts to rule the inheritance as a joint marital asset.
Ultimately, every state has their own slightly different laws on what they consider a marital asset. Even assets inherited before a marriage can end up being subject to divorce, if they are used for marital expenses. If you’re concerned about a potential inheritance being torn apart by a potential divorce, you should consult with a legal expert. They can best advise you how to spend (or not spend) an inheritance, in order to keep it protected. A prenuptial agreement is always an option too.
Other Ways To Protect an Inheritance
Donating a portion of your inheritance to a charity can actually save you some money. You may need to run the math to convince yourself, though. If you find yourself in a situation where you have a large tax bill thanks to receiving an inheritance, look into donation options. The right-sized charitable donation (to a qualifying charity) could off-set your tax liability enough to save you money.
Another popular way to avoid large inheritance or estate taxes is to simply gift the money to your heirs before you pass. If you can spare the money, consider giving your heirs an annual gift of cash. As long as you need it under the taxable limit ($16,000 in 2022), it won’t be subject to gift taxes. It also reduces the value of your overall estate. That, in turn, could result in lower estate taxes when you do pass away. That’s also a good thing for your surviving loved ones.
Consult a Professional
Inheritances, wills, trusts, estate planning, probate, and tax returns can all get complicated in a hurry. Our very best advice is that you should consult a professional. Even if you think the inheritance you’re going to leave (or receive) is modest, a professional estate planner can make sure you maximize the amount of money and assets that remains in your family.
You should do this as early as possible. Don’t wait until you are retired to start planning how your assets will be distributed, and to whom. Make a last will and testament in your 30s or 40s, and update it every five years. Ensure that your investments, real estate, and any other assets are going to be appropriately divided when you’re gone.
Lastly, don’t be afraid to sit your family down and discuss how you want your inheritance to work. It may feel a bit morbid to be talking about something that inevitably means you have died. However, setting clear expectations with your heirs can be beneficial. It will go a long way to making sure your inheritance isn’t whittled away by legal fees if your heirs start fighting over the pieces.
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