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Inheritances Often Come Loaded With Risks

By Chris Latham September 23, 2013

When clients first mention that they expect to receive an inheritance, they rarely have all their facts straight. In fact, their expectations can be seriously wide of the mark. So prudent advisors use that conversation as the jumping-off point for a meticulous planning process. Taxes that may be due on the windfall, potential intra-family squabbles and an urge to splurge are among the important issues advisors should tackle with clients before they see a penny of the money.

If they ever do, that is.

Uncertainty being the only certain thing about impending inheritances, John Kvale of J.K. Financial in Dallas doesn’t insert any additional sums into a client’s financial plan until the heir has taken possession of the bequest. “Life happens,” says Kvale, whose firm manages about $70 million. “That inheritance may not occur.” But if there’s a strong likelihood that the client will take a tax hit, Kvale builds it into the client’s financial projections.

Kvale peppers putative heirs with questions. In what form is the inheritance, and how large is it now? Who or what has custody of the assets? Can the client speak to the person making the bequest about the will and its terms? Ideally, the client discussed all these details with the bequeather while that person was mentally competent. But all too often, the dialogue never takes place.

It’s not uncommon for the value of an inheritance to drop by 30% to 50% because of taxes, says Russell Francis of Portland Fixed Income Specialists, a Beaverton, Ore., firm with about $41 million in AUM. The total tax hit depends on the states of residence of the heir and the deceased; their ages and relationship to each other; whether the transfer consists of cash, securities or physical property; whether the transfer is from a qualified account or a trust; and over what time period distributions are received.

John Kvale
Sometimes it makes sense for the trust or estate to pay taxes before the inheritance is distributed — for example, when it is to be divided among heirs. Beneficiaries generally do not pay taxes on homes or securities unless they sell those assets and face capital gains, says Francis. However, large estates often include property that heirs are forced to sell because there’s not enough cash to cover inheritance taxes.

“Life goals and types of investment assets can be changed after the money is inherited,” Francis says. “The big planning issue that needs to be addressed immediately is taxes.”

Emotional Impact

When there are multiple heirs, advisors frequently wind up moderating disputes. For example, if one heir lacked clarity about the status of a trust or will while a parent was alive but a sibling was kept informed, mistrust can bubble up after the parent dies.

Family squabbles that devolve into lawsuits seem increasingly common to Randy Carver, an independent affiliate of Raymond James whose Mentor, Ohio, team manages about $800 million. Litigation can erupt when an heir mistakenly thinks he or she is the sole beneficiary or believes that a sibling misspent part of their parents’ wealth, Carver says.

“The more communication there is among family members, the less chance of hard feelings,” says Carver.

Another challenge arises for advisors once a client takes possession of an inheritance: managing impulse spending or other reactions. Clients who aren’t crazy about their jobs have been known to quit, either to become entrepreneurs or to retire early, according to Rocky Farr of Diesslin & Associates, whose Fort Worth, Tex., firm manages about $720 million. Others give in to long-suppressed desires for a McMansion or a shiny sports car.

This is where clear, concise retirement projections come in handy, says Farr. Advisors can do Monte Carlo simulations with and without inheritance figures, to make sure clients stay on track in funding their accounts. For example, a simulation might show a client who has inherited a bundle that whereas a $1 million home would be affordable, a $2 million home would sabotage retirement goals. “It’s not really us telling them that,” Farr says. “It’s the numbers telling them that.”