Sunday, June 13, 2021

Preparing Non-Moneyed Heirs for a Seven-Figure Windfall

Even the disciplined savers need advice — and taxes may not be the chief concern.

DJ Hunt
DJ Hunt

As advisors, we will certainly all have clients that inherit assets from the previous generation. In fact, a 2019 study by United Income suggests that 20% of households in the U.S. stand to receive some sort of inheritance in any given year. That same study indicates that the average inheritance has grown from $169,000 in 1989 to $295,000 in 2016, with the median being just over $54,000.

While a $54,000 windfall would not likely create a need for major updates to the financial plans currently in place for most clients, we can look at one real life inheritance situation that dramatically effects a client’s life, and how some new wrinkles from the SECURE Act present the need for a careful planning strategy.

I recently met with a couple who are in the process of inheriting from the wife’s father. His estate is being split between the wife and her three siblings. Dad’s estate totals $3.8 million, one million of which was a home. So, this couple, in their early 60s, have received $700,000 split about equally between an inherited IRA and a taxable investment account, and an additional $250,000 in proceeds from the sale of her dad’s home.

In addition to this inheritance being somewhere around triple the average amount from the United Income study, there are a few additional details that move this case outside of the usual client situation. This couple has never had anything remotely approaching this amount of money. They have very little savings, no retirement accounts of their own, no investing experience and no current income (due to a COVID-related job loss). They also have a fully disabled adult daughter living with them. To their credit, although they have never made or had much money, they have always been good managers of their budget and are completely debt free. This last part turns out to be of utmost importance, as it will allow 100% of the inherited money to go toward building an income stream for the rest of their lives, rather than paying off debt.

This inheritance has the potential to have a huge positive impact on their lives. Implementing a sound portfolio strategy in the inherited IRA and taxable account will provide a pathway to replacing the income lost due to the COVID job loss, allowing them to fully retire with dignity. Additionally, they have always rented and now have elected to use the proceeds from the sale of her dad’s home to pay cash for a home of their own. This is their way of honoring where that portion of the inheritance comes from.

Prior to the SECURE Act, which removed the option for non-spouse beneficiaries to implement the “stretch IRA” by taking the annual required minimum distributions over their own life expectancy, a financial planner might have been tempted to plan this family’s retirement cash flow by claiming Social Security at the earliest possible time (which in this instance would be immediately), using the smaller extended RMDs over the wife’s lifetime, and leaning on withdrawals from the taxable account to shore up the monthly budget.

Now, because the SECURE Act requires non-spousal inherited IRAs to be completely emptied within 10 years, we are presented with the opportunity to implement a strategy that plans for largely even annual distributions over that time frame. This scenario results in larger annual IRA withdrawals than is necessary to meet the family’s cash flow needs.

A surplus is thus created that can be systematically added to the taxable account. This dollar-cost averaging discipline, done over a decade, has the potential to grow the taxable account to a seven-figure balance by the time the inherited IRA is fully depleted. Taking the IRA distributions evenly over 10 years also gives the couple the ability to delay their Social Security until age 70, when it will be the maximum benefit.

Ultimately, this all culminates with the couple not only being able to live a dignified life in retirement but sets them up to potentially leave a substantial amount to their daughter to support her in comfort for the rest of her life as well.

Of course, this plan like all plans is only good on paper. While this couple has, up until now, demonstrated excellent financial discipline, we as financial planners have all seen clients receive a large windfall and immediately turn into completely different people. For the first time in their lives, these folks will have what to them is a decent amount of disposable income. It will be incumbent on us as planners, advisors, teachers and counselors to walk beside this family, helping them make good decisions.

The change to the SECURE Act that discontinued the “stretch IRA” has normally been discussed as a negative in financial planning circles. The usual complaints are centered around tax planning and how the new rule accelerates the burden for beneficiaries in higher income brackets. This case, however, shows that taxes are not the most important planning aspect for every client and the rule change forcing faster distribution from an inherited IRA shines light on planning avenues that might have previously been overlooked.

DJ Hunt, CFP® is a fee-only financial advisor with Moisand Fitzgerald Tamayo, LLC. in Melbourne, Florida. His clients include working professionals, business owners and retirees. DJ can be reached at dj@moisandfitzgerald.com.

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