Your inheritance has arrived. Now what?

Transcription

1 Your inheritance has arrived. Now what? Schlindwein Associates Guide How to Effectively Integrate Inherited Assets into Your Investment Portfolio Richard W. Jackson Principal

2 Introduction: A grab bag of financial assets It is common to hear that someone has inherited money but it s rare for someone to receive actual money. The financial assets you receive from an inheritance are not necessarily right for your financial goals. In addition to real estate, jewelry and other tangible possessions, an inheritance typically includes a miscellany of financial assets. It is not unusual for these assets to include: Separate stocks and bonds Mutual funds or closed end funds Exchange traded funds (ETFs) Money market funds Bank accounts Certificates of Deposit (CDs) One or more variable annuities Stock options (in states that allow stock options to be inherited) Less mainstream investments, such as master limited partnerships, real estate investment trusts (REITs) or direct lending funds. These assets may have suited their former owner s financial goals; however, they are not necessarily right for you, their new owner. It can be a deceptively complicated exercise to integrate the financial assets from even a modest inheritance into your own investment portfolio. You may be compelled to make decisions that touch upon investment timing, your portfolio s asset allocation, the viability of the assets you receive, and your tax situation. Making the right decisions is rarely a simple, straightforward exercise.

3 A Disciplined Approach Inheritors often use inconsistent criteria and an irregular process when deciding which investments to keep or jettison. Without a comprehensive approach and a predetermined set of decision metrics, it s easy to lose sight of the whole picture. Decisions that may appear reasonable in isolation can prove counter productive when viewed in relation to your entire financial situation. In general, a disciplined approach to deciding how to treat inherited financial assets involves these five steps: Inheritance related decisions that appear reasonable in isolation can prove counterproductive when viewed in relation to your entire financial situation. 1. Review your cash flow needs 2. Be cognizant of your asset allocation 3. Evaluate the quality of individual investments 4. Be mindful of taxes 5. Understand emotional and financial tradeoffs It will be helpful to look at each step in more detail. Case history: A costly oversight An executive in his fifties inherited a Roth IRA that had originally been passed on to his mother by his father. Remembering how his mother had withdrawn cash from the Roth IRA without tax consequences, he decided to transfer the money into a 529 account established years ago for his son, an only child. At age nineteen his son dropped out of college. Nevertheless, the executive continued to maintain the 529 plan, hoping his son would someday opt to return to school. The following year, however, the executive was laid off at age 61. After nine months, he decided his employment prospects were limited and drew up a plan to self fund a start up business with the money accumulated in the 529 plan. He understood this would be a non qualified withdrawal, but assumed the money would remain tax free, since it originated from an inherited Roth IRA. This assumption proved incorrect. The withdrawn money immediately lost its tax exempt status, and therefore left him with less capital than he had anticipated. If he had maintained the inherited Roth IRA, withdrawals for either his son s education or his new business would not have been subject to taxes. Despite all of his planning, a single misjudgment cost him dearly.

4 1. Review Cash Flow Needs Once you receive an inheritance, a fundamental question is whether you need or desire cash now or in the near future. Inheritors often take steps to: Before converting mutual funds, ETFs, annuities or other holdings into cash, check with your financial advisor and accountant to make certain you have all the information you need to avoid unfavorable outcomes. Pay down debt (from credit cards, bank loans, a mortgage, etc.) Meet a sizeable expenditure, such as a child s tuition Make a charitable donation Supplement current income. If you decide to deploy cash for these or other purposes, the obvious sources among your inherited assets are money market funds, bank accounts, and CDs (once they have matured). Converting other holdings mutual funds, ETFs, annuities, REITs, separate stocks and bonds, etc. into cash is not always a simple endeavor. Before taking any steps in this regard, check with your financial advisor and accountant to make certain you have all the information you need to avoid unfavorable outcomes from the perspective of: Taxes Bond maturities Withdrawal penalties Other issues that may not be immediately self evident.

5 2. Be Cognizant of Your Asset Allocation Adding inherited assets to your portfolio arbitrarily can expose you to too much investment risk or too little potential return. Your asset allocation how stocks, bonds, money market funds and other assets are apportioned in your portfolio should provide you with the right degree of risk and potential return, given your financial goals. For example, an asset mix with 80% in stocks may be too risky, while an asset mix with only 20% in stocks may offer too little growth. Maintaining the right balance of stocks, bonds and other asset classes is likely to be the major determinant of your long term investment success. You do not want to add inherited investments to your portfolio indiscriminately, as this could throw your portfolio out of balance. For instance, let s say your inherited assets include a highly regarded stock mutual fund. Adding this fund to your current portfolio would immediately alter the existing ratio of stocks to bonds to cash. To maintain the proper ratio in your portfolio, you might need to reduce other stock positions or bolster your fixed income and cash positions. You also may inherit types of financial assets that do not currently exist in your portfolio. In some cases, these assets may be able to provide a wider range of return opportunities and enhance your portfolio s risk profile through greater diversification. Let s say you have inherited a real estate fund. Research shows that these funds rarely tend to move in tandem with mainstream stock funds. In effect, real estate funds are prone to zig when stock funds zag, and vice versa. As a result, adding this exposure to your portfolio could help dampen some of its overall stock risk. It is important to be aware that adding inherited assets to your portfolio can alter its risk/return profile, even if the asset allocation percentages remain the same. At first glance, inherited funds or individual securities may appear to be similar to your portfolio s existing investments. However, closer analysis might reveal they

6 offer meaningfully different risk levels. Consider two small cap stock funds. How they behave over time may vary significantly, based on their respective manager s investment approach. One fund may experience a substantially higher degree of market volatility than the other. Just because the allocation remains the same, does not necessarily mean you are exposed to the same degree of risk. Case history: Using inherited assets to enhance a portfolio The adult children of a deceased Schlindwein Associates client recently asked us for assistance. The investment portfolio we had constructed for the parents contained a number of market exposures that their own portfolios lacked. They wished to know if these assets commodities, real estate investment trusts (REITs) and replicated hedge fund strategies could enhance their own portfolios. We explained how these particular alternative assets had provided their parents portfolio with greater diversification and a more efficient risk profile. To bring these same qualities to the children s portfolios, we analyzed their respective asset allocations, so as to determine what overall changes might be required. Since each child had unique financial goals, our recommendations differed for each portfolio. Once this analysis was completed, we transferred the funds in question from the parents portfolios to the children s portfolios. Consistent with their existing asset allocations, we also helped the children augment their portfolios with many of the parents traditional investments.

7 3. Evaluate the Quality of Individual Investments It is entirely possible to inherit funds, annuities and individual securities that fit perfectly with your asset allocation but lack other important qualities. At a minimum, you may want to ask these questions: The all in fees of mutual funds, annuities and other pooled investment vehicles are not always self evident. Pooled Investment Vehicles (Mutual funds, ETFs, annuities, etc.) Are the fees/expense ratios favorable? Pricing among similar investment products can vary widely. High fees or expense ratios are not always a sign of quality. It is important to read prospectuses carefully, because total fees are not always self evident. Has the fund been able to perform favorably compared to index funds over the past five years, once fees are deducted? If not, you may want to consider replacing it. How does the fund s volatility compare to similar funds? A fund with above average volatility may not necessarily deliver better returns over time. If you have inherited annuities, do they require surrender charges if you wish to sell them? Surrender provisions are often written in legalese that can be difficult to understand. Provisions also can differ widely among products sponsored by the same insurance carrier. Is there evidence that the investment is managed in a tax efficient manner? Individual Securities For a bond: Does it pay an attractive interest rate, and is it worth holding until it matures? For a stock: Is it worth keeping because of a favorable dividend, prospect for price appreciation, and/or attractive cost basis?

8 4. Be Mindful of Taxes A large portion of inheritances today arrive within IRAs, Roth IRAs and other tax deferred plans, including 401(k)s. It is vital for you to know the inheritance related rules governing these vehicles. These regulations are not always intuitive. Please refer to the Addendum of this white paper for more information on tax deferred plans, and be certain to consult with your financial advisor or accountant before making a move. In any given year, inheritance related tax losses can be a far larger risk than market losses if an investor is unaware of the tax code. Similarly, it is essential to understand the tax rules tied to: Selling stocks or bonds The disposition of mutual funds Terminating or liquidating variable annuities or any insurance based product. Case history: A nearly neglected distribution A Schlindwein Associates client in his mid fifties inherited a traditional IRA in November, following his mother s death. He wisely decided to keep the money in the IRA but asked us to integrate it into his overall asset allocation. At the onset of this process, we asked the client if his mother had taken out her required minimum distribution (RMD) for that year, as required by the tax code. If she hadn t, he would be responsible for doing so by year end. Failure to follow through could have triggered a 50 percent penalty on the unmet portion of the RMD. The mother had been quite ill before her death, and there was no readily available paperwork to show she had taken her RMD for the year. A consultation with the mother s accountant confirmed that she had not completed the necessary step. Our client was able to do so, on her behalf, before December 31 thereby avoiding an onerous penalty.

9 5. Understand Emotional and Financial Tradeoffs Some inheritors find it difficult to approach an inheritance from a purely practical perspective, given that it is a gift from their parents or other benefactors for whom they have strong feelings. If you have a strong emotional attachment to an inherited asset, it is essential to be aware of the tradeoffs. Clients often assume that Schlindwein Associates always favors a purely financial decision in regard to the disposition of inherited financial assets. This is not categorically true. We understand there is a need for inheritors to acknowledge emotions, and believe sentiment can be a legitimate decision criterion at times. It is common for inheritors to feel an attachment to a large block of stock their parents accumulated. Indeed, we have had discussions with clients who felt ambivalent about selling a certain position because, My parents considered this to be a very important part of their portfolio. When sentiment and practical considerations are at odds, there may be a strong argument to dispose of an asset if: It increases the overall risk of your investment portfolio by a significant degree The magnitude of a potentially negative return would severely harm your finances You are not planning to pass the investment on to your children or other close beneficiaries. From both an emotional and financial standpoint, resolving these issues can be difficult. However, it is always helpful to evaluate every consideration.

10 Addendum Inheriting IRA Assets as a Non Spouse Beneficiary, i.e., from parents or other relatives I. Traditional, Rollover, SEP, Simple IRAs and Qualified Retirement Plans Option 1: Open an Inherited IRA Benefits Assets left in account continue to grow on a tax deferred basis No 10% early withdrawal penalty Ability to name own beneficiaries Action Required Open a properly titled Inherited IRA in the name of the original account owner for your benefit When multiple beneficiaries are involved you must establish the inherited IRA by 12/31 following the year of death in order to retain the right to use your own single life expectancy for distributions. Note: Cannot take an inherited non Roth IRA and change it directly to a Roth IRA. Accessibility The funds are available for distribution at any time but are considered taxable when distributed. If account owner was under 70 ½ at death You can take RMD over your single life expectancy provided you begin distributions no later than 12/31 following the year of death. You also have the option of delaying distributions but will have to have the account fully distributed at the end of the fifth year following death If the account owner was over 70 ½ at death RMD will be based on your life expectancy You must begin no later than 12/31 following the year of death

11 If the original owner did not take the RMD in the year of death you are required to take the distribution by the end of that year. Option 2: Take a lump sum distribution Benefits No 10% penalty owed Actions Complete a simple set of paperwork and all the assets will be distributed to you Accessibility Funds will be received at once You will pay income tax on the full amount received which will likely push you into a higher if not the highest tax bracket decreasing the actual cash value you receive. II. Roth IRA Option 1: Open an Inherited Roth IRA Benefits Assets left in account continue to grow on a tax deferred basis No 10% early withdrawal penalty Ability to name own beneficiaries Action Required Open a properly titled Inherited Roth IRA held in your name. When multiple beneficiaries are involved you must establish the inherited IRA by 12/31 following the year of death in order to retain the right to use your own single life expectancy for distributions. Accessibility Funds are available for distribution at any time. Distributions will be tax free if the five year holding period has passed. If the five year holding period has not passed only earnings will be taxed. RMD based upon your life expectancy must begin no later than 12/31 following the year of death.

12 You may choose to delay distributions until the end of the fifth year following the year of death by which time the account must be fully distributed. Option 2: Lump Sum from a qualified plan IRA, 401(k) 403(n) SEP, KEOGH Benefits If the five year holding period has been met at the time of death, there will be no taxes accessed on the distribution No 10% owed as a pre age 59 distribution tax penalty Action Required Complete simple set of paperwork and assets will be distributed to you. Accessibility Funds are available at once Pushes the beneficiary into a higher tax bracket Will be required to withhold 20%