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WILLIAM LAKO: It’s ill-advised to count on an inheritance to fund your retirement

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I recently worked with an investor who “planned on inheriting his parent’s wealth” and wanted me to factor this money into his financial plan. I am always hesitant to do so in most situations. Inheritances can be unpredictable. Furthermore, the reality is that most people will not inherit enough to even pay for one year of retirement.

The average inheritance received was $46,200 according to the Federal Reserve’s Survey of Consumer Finances, compared to the average expected $72,200. The Fed’s survey also showed that even in the wealthiest families, inheritances were roughly 15% lower than expected, while with the bottom 50% of families, inheritances were less than 65% of expected.

So why is there such a large gap? Anticipated inheritances can be reduced by long-term care events, estate taxes, market conditions, paying the deceased’s debts and having to share with multiple heirs or charities, just to name a few. For example, let’s say you’re expecting to receive a substantial inheritance of $300,000. However, we experience a market recession like we had in early 2020, where the S&P Index loses 34%, and your father suffers from a long-term care event that results in your parents spending $124,000 more than anticipated. Your inheritance could now be around $74,000. While that is still more than average, it is substantially less than anticipated.

As an adviser, I often see investors opt to skip a generation, leaving their wealth in trusts for grandchildren. While their children may be trustees, the trust assets must be used to benefit of the grandchildren. Furthermore, there may be conditions in accessing the wealth—for example, the beneficiary must be earning a bachelor’s degree.

Another point to consider is how you inherit the wealth, as all assets are not equal. If you were to inherit a $300,000 house, you could likely sell the house for a profit as you’ll receive a step-up in basis and should only owe capital gains on any increase from the fair market value on the day the owner died. You could rent the house and let the asset produce income for you, which would delay any capital gains until you sell the home. Your other option would be to move into the house, reducing your expenses, increasing your cash flow, and likely only owing annual property tax on the home.

However, if you inherit a $300,000 IRA, any withdrawals are immediately taxable as ordinary income. Furthermore, the SECURE Act changed the rules for inherited retirement accounts, requiring heirs to withdraw the money within 10 years of the original owner’s death. This could result in a significant tax burden, thus reducing your new-found wealth.

With so many variables surrounding an inheritance, you can see why it is ill-advised to count on a windfall to fund your retirement. If anything, an inheritance may allow you to pay down debt or pay off a mortgage, which may allow you to save more of your own income for retirement.