How Does Inheritance Work and What Should You Expect?

Inheritance is receiving assets from someone who has passed away. Many people are not prepared to pass on assets or receive them. As it turns out, the passing of property and assets doesn’t always go as expected or planned. Plus, though it may seem like a windfall, getting an inheritance is rarely as easy as depositing a check. It’s important to understand how it works, and how it’s taxed before getting started. If you have questions about your inheritance’s specifics, consider speaking with a financial advisor.

How Inheritance Works When There’s a Will

Survivors receive the estate through inheritance when someone dies and there is no living spouse. 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.

Inheritance Terms to Know

Understanding inheritance terms is crucial for anyone involved in estate planning or managing a loved one’s estate. Familiarizing yourself with these terms can help you navigate the legal and financial aspects of inheritance more effectively. Below are some key inheritance terms to know:

Beneficiary: A beneficiary is an individual or entity designated to receive assets from a will, trust, or insurance policy. Understanding who the beneficiaries are is essential for ensuring that the estate is distributed according to the deceased’s wishes.
Executor: The executor is the person appointed to administer the estate of a deceased person. This role involves managing the estate’s assets, paying off debts, and distributing the remaining assets to the beneficiaries.
Probate: Probate is the legal process of validating a will and overseeing the distribution of an estate. It involves court supervision to ensure that the deceased’s assets are distributed according to their will or state law if no will exists.
Intestate: When someone dies intestate, it means they have passed away without a valid will. In such cases, state laws determine how the deceased’s assets are distributed, often prioritizing close relatives.
Trust: A trust is a legal arrangement where one party holds assets on behalf of another. Trusts can be used to manage and protect assets, reduce estate taxes, and avoid probate.
Heir: An heir is a person legally entitled to inherit a portion of the estate of a deceased person, typically in the absence of a will. Heirs are usually close family members, such as children or spouses.

Understanding these inheritance terms can significantly ease the process of estate planning and administration. By familiarizing yourself with these concepts, you can ensure that your estate is managed and distributed according to your wishes, providing peace of mind for you and your loved ones.

Bottom Line

Coming into a large inheritance doesn’t guarantee financial security. Without a plan, it’s very easy to blow a windfall. The sudden rush of money can spark lifestyle inflation and irrational behavior. Beneficiaries are sometimes in worse financial shape after inheritance than before. If you’re going to inherit a sizable chunk of change, be realistic about the amount you’re inheriting, assess your current financial situation, consider your goals, establish boundaries and spend thoughtfully. Debt repayment and investing should be top priorities.

Tips for Managing an Inheritance

Don’t go it alone. Getting an inheritance is a great time to find a financial advisor. You may be unsure of how best to use your newfound wealth, and you’ll likely have questions. An advisor can help you draft a financial plan with your windfall factored in and decide how to invest your money so it grows over the long term. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Realistically assess your inheritance and prioritize your goals. Are you behind on saving for retirement? Are there high-interest debts you have yet to pay off? Have you been meaning to start saving for your child’s education? Many advisors recommend using inheritance to first create a rainy day fund, then pay down debts and then to fund retirement savings.