UNITED STATES—Every year, an estimated 1.7 million American households receive an inheritance. However, studies have found that nearly three-quarters of beneficiaries lose their inheritance within a few years and over one-third of all inheritors see no change or even a decline in their wealth after inheriting money and other assets.
While receiving a bequest from a friend or relative should represent a financial blessing, an inheritance can come with strings attached. Here are three common setbacks beneficiaries may face after inheriting cash, property, and investments below:
Family conflicts. Research from TD Wealth found that 44 percent of lawyers, trust officers and accountants say family conflicts are the most common setback associated with receiving an inheritance. Oftentimes, conflicts arise when individuals pass on without leaving behind an estate plan. Without a clearly drafted estate plan to follow, beneficiary distributions may be left up to probate court.
But in some situations, family conflicts can arise even after when a sophisticated estate plan is enforced. This is particularly common with estate plans that rely too heavily on trusts.
A common estate planning tool, a trust is a legal device with instructions on how and when assets should be distributed to beneficiaries. Many people leverage trusts to attempt to shield their assets from estates taxes or to keep them from impacting their beneficiary’s SSI benefits. However, trusts carry the potential to be mismanaged and result in expensive and lengthy legal conflicts. This can occur if an adverse trustee is appointed and mismanages the trust — for instance, by favoring one beneficiary over the others or making reckless investments with the assets. Filing a claim against an adverse trustee can be a complex and costly process that results in stress and division among beneficiaries while taking a sizeable bite out of their inheritances.
Taxes. Upon receiving an inheritance, beneficiaries could be affected by or liable for paying different taxes, including:
- Estate tax. This is a type of tax applied to the value of a decedent’s assets, properties, and financial accounts upon their death. The amount the estate is taxed may vary depending on the value of the estate and the state where the decedent lived. Although it is typically the executor of the estate, not the beneficiary, who is responsible for handling estate tax, it is levied on the value of the estate and may impact the amount beneficiaries receive.
As of 2019, the federal estate tax limit is $11.4 million per individual. Depending on the value of the estate, it may be taxed up to 40 percent. In addition to the federal government, 13 states and Washington D.C. impose additional estate taxes with their own exemption thresholds.
- Inheritance tax. While estate taxes are paid out of the decedent’s estate, inheritance tax is paid by the beneficiary. As of 2019, six states collect an inheritance tax, including Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. The rate of inheritance tax beneficiaries must pay may depend on their state of residence, their relationship to the dependent, and the value of the inheritance.
Certain family member beneficiaries living in states that enforce an inheritance tax may qualify for an exemption. Generally, spouses are exempt from inheritance taxes if they inherit assets from a deceased spouse. Children and other dependents may also qualify for an exemption, though in some instances only part of their inheritance may be exempt. Typically, beneficiaries who are not related to the decedent will be charged a higher rate of inheritance tax.
- Capital gains tax. Finally, beneficiaries may be liable to pay capital gains tax on their inheritance in certain circumstances. Recipients may be subject to a capital gains tax should they make a profit selling inherited assets. For instance, if the decedent leaves $300,000 in stocks and the beneficiary sells them for $500,000 a few years later, the beneficiary may have to pay capital gains tax on the $200,000 profit.
Beneficiaries may also be liable to pay capital gain tax on an inheritance that generates taxable income. One common example is inherited 401k or IRA accounts. With these types of inherited financial accounts, beneficiaries may have to pay capital gains tax on distributions they take.
Impact on government benefits. In addition to affecting tax burden, receiving an inheritance could impact a beneficiary’s Supplemental Security Income (SSI) benefits. Supplemental Security Income is a government program that offers benefits to disabled individuals with limited income and resources. Because SSI is a needs-based program, any increase in assets and income due to recently inherited funds could result in a beneficiary’s SSI payments being cut or eliminated.
Beneficiaries receiving SSI payments are required to report their increase in resources within 10 days into the first new month after they receive an inheritance. To be eligible to receive SSI payments, recipients must not have assets over $2,000 as an individual or $3,000 for a couple. If a one-time, lump-sum inheritance increases their assets above these thresholds, beneficiaries could risk losing their SSI benefits.
When used to shield wealth for future generations, trusts can often backfire. Estate tax exemptions are typically high, making the primary use of trusts as a tax planning tool not relevant for trusts smaller than 10 million per beneficiary. Those seeking to leave behind an inheritance for the benefit of their loved ones should remember that a trust is not always the right choice. For families that do choose to set up a trust, it is critical to appoint a reliable and competent trustee while being careful to draft the trust using language that allows the appointed agent’s removal in the event of mismanagement.