Inheriting a windfall can be a life-changing event, especially if you currently don’t make much money. Yet what you also quickly find out is that it can be an extremely taxing event, both emotionally and literally.
The government will be gunning for its share of your money, so handling the inheritance will require planning on your part to ensure the Tax Man doesn’t get any more than he’s due. Unfortunately, the entire system is extremely complex so your best course of action is to go slow and get competent advice from a financial planner and tax professional.
This was brought to mind by a Redditor on the r/chubbyFIRE subreddit who recently received a windfall inheritance of approximately $500,000 in the form of a taxable brokerage account. Made up mostly of mutual funds and index funds, he wondered whether it was better to put the money into a Roth 401(k) or a traditional 401(k) account.
24/7 Wall St. Key Points:
- Inheriting a large windfall can be a life-changing event for many, so thoughtful consideration for handling its disposition is necessary.
- There are pros and cons to every choice, but the tax-free growth opportunities of a Roth 401(k) are very often tough to beat.
- Don’t make any decisions quickly or alone. Assemble a team of financial planners, estate planners, and tax professionals to guide you through the labyrinth of options.
- Also: Take this quiz to see if you’re on track to retire (Sponsored)
Is a Roth right for you?
There are a lot of considerations here, and I’m not a financial planner or tax professional, so these are only my opinions, but very broadly speaking, a Roth 401(k) is a preferable option. You can mix and match deferrals and make some pre-tax contributions and some post-tax contributions, so that over the next few decades before you retire, the gains on the investments will be phenomenal.
Historically speaking, the stock market has grown at a fairly consistent rate of around 10% or so a year, on average. That means a $500,000 account could be worth some $8.7 million in 30 years, though obviously it wouldn’t grow exactly at the historical rate every year.
In a Roth account, those gains can be withdrawn tax-free. There are also no required minimum distributions (RMDs) kicking in at age 73 from Roth 401(k)s as there are with traditional IRAs and 401(k) accounts. A lot, though, depends on your tax bracket, which also depends on how much you make.
There are times traditional 401(k)s make sense
Higher-income individuals may find a traditional 401(k) preferable because contributions are pre-tax, so being able to deduct them for tax savings might make sense and be more valuable.
Still, you might want to have a mix of options, including Roth and traditional 401(k)s for greater control and flexibility over money going in and coming out. Also consider the dividends investments in index and mutual funds throw off, which could be taxable, so make sure you set them to reinvest.
Moreover, make sure the value of the assets are stepped up to account for their growth over time. For example, if an index fund was originally bought for $10, but at the time of the inheritance it was worth $100, you want to make sure the higher value is recorded upon transfer otherwise you will pay capital gains taxes on those gains.
While it doesn’t seem to apply to this particular Redditor’s situation as he inherited a taxable brokerage account, if you inherit an IRA or a 401(k) you also need to be mindful the SECURE Act of 2019 did away with so-called stretch IRAs.
These IRAs allowed beneficiaries to “stretch” any taxable distributions from the retirement accounts over the individual’s life expectancy, minimizing the tax bite. However, Congress did away with that for any inheritances received after 2019. Now you have just 10 years to “clean out” the account, which for a windfall inheritance, could substantially increase your income and tax liability.
Key takeaways
Ultimately, there is no one right answer when it comes to a windfall inheritance, which is why consulting with professionals is essential. A lot will be determined by what your current financial situation is and what your financial and retirement goals are. While Roth 401(k)s often make the most sense, it is not always the case, especially for high income individuals. And for greatest flexibility, a mix of options may be best.
Inheriting a large sum of money can be life altering, but scary at the same time. So take your time and assemble a team to help you through the intricacies of making the most of the money that’s been left to you.
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