Incorporating an Inheritance into your Personal Legacy

If you suddenly inherited $400,000, what would you do with it?

Right away, a lot of people would probably think of eliminating their largest debt and respond, “Pay off my house!” But that may not be the best – or smartest – choice. If you bought your house more than four years ago, your interest rate is probably between three and four percent. Using your inheritance to satisfy your mortgage would save you from paying that interest… But at what cost?

The average long-term stock market return is currently about 10 percent. If, instead of paying off your mortgage, you were to add that money to your investment accounts, the gains you could realize would far exceed what you’d save in mortgage interest. The chance of growing that $400,000 to as much as $800,000 through careful investing is much greater than the chance of your home’s value increasing by 100 percent. And, if you plan for your current home to be your “forever home,” consider the effect on your heirs: If you have more than one child, that paid-off house is likely to be sold. Each child would receive a fraction of the sale price – a dilution of the asset’s value.

Scenarios like this are the reason why so many inheritances are completely gone by the third generation. People inherit money and then spend it without having a thoroughly considered plan for doing so. That plan can begin with you and your estate plan.  

Estate planning: Not just for millionaires.

The most common misconception about estate planning is that it’s only important for the fantastically rich. Not true. Your estate is comprised of everything you own; no matter how large or how modest, everyone has an estate. And, with proper estate planning, you can provide for your family for generations to come.

However, if you want your legacy to last, simply leaving your assets to your children in your will and hoping they make wise decisions may not be enough. You can take steps now to ensure that your assets are distributed to your heirs in a more structured manner, ultimately helping them avoid unwise financial decisions and even protecting them from excess taxation.

Consider putting your trust in a Trust

Much like generational wealth itself, Trusts are often perceived as being only for the extremely wealthy. In reality, Trusts are an excellent option for almost anyone with an estate to pass on. Trusts provide several tools to help you accomplish your goals for your heirs:

• Wills are sometimes subject to challenges from family members who feel they should get a larger share of the estate (which typically involves hiring attorneys and accountants, potentially draining thousands of dollars from the estate). Trusts, on the other hand, are much less vulnerable to challenge.
• Even if your Will isn’t challenged, it will go through the probate process, which could take up to a year (and also involves hiring a lawyer). Because Trusts assign their assets to beneficiaries while you’re still alive, the probate process is not usually required, meaning more of the assets you leave behind will benefit your heirs.
• A Trust allows you to set the rules about when and in what amount funds are distributed from it. An inheritance through a Will is usually distributed to beneficiaries as a lump sum. One popular Trust technique is to tie withdrawals to the salaries of beneficiaries, meaning that annual distributions from the Trust are made in amounts equal to an heir’s income for that year. This helps keep the Trust’s corpus healthy by not distributing assets too quickly while also encouraging your heirs to pursue careers they enjoy (regardless of salary).

Don’t forget about tax planning:

It's important to think about how taxes may impact your estate when leaving a legacy for the next generation. If done properly, your heirs can inherit tax-free or at least pay a lot less in taxes than they otherwise would.

Currently, the estate tax exemption amount is $13.61 million per individual and $27.22 million for couples. But when the Tax Cuts and Jobs Act (TCJA) expires at the end of 2025, federal estate tax limits will drop back to around $7 million (adjusted for inflation) per individual, with anything above that dollar amount subject to a 40 percent tax. Making it worse: the assets in tax-deferred retirement accounts are subject to even more taxes upon withdrawal, significantly adding to your heirs’ tax bill if you name them as beneficiaries. Recent changes to tax laws eliminated the “stretch IRA” option, requiring non-spouse beneficiaries to liquidate the entire balance of a retirement account within 10 years, rather than spreading it over their lifetimes. Financial planning professionals project that this change could result in about one-third of an inherited IRA’s balance being paid in taxes to the IRS.

The best solution? Leaving other assets to your loved ones and designating all or part of your retirement assets to a qualified charity, like Drexel University. This offers two distinct tax advantages:

• Decreases the estate tax burden for your family. Your assets will pass directly to Drexel, so your estate will be eligible for a federal estate tax charitable deduction on the full value of the donated amount.
• Makes a significant impact for future Drexel students. As a qualified charity, Drexel will not pay income taxes on your donation when it receives assets from your retirement account and will receive the entire amount to use as you have directed.

Smart estate planning is important and, in many ways, an additional gift for your heirs and for you through the peace of mind it provides.

Questions? Contact David Toll, senior associate vice president in Drexel’s Office of Gift Planning at 215.895.1882 or giftplanning@drexel.edu

Not intended to serve as tax or legal advice. Drexel University encourages you to consult with your own professional advisors regarding the topics outlined within this Planning Tip of the Month.