In our latest Thimbleberry U episode, we dive into inheriting investments.. Amy starts by differentiating between account types and actual investments. She focuses on the importance of the holdings in an account.
Amy explains tax implications of inheriting investments, especially the step-up in basis, using an example to show how this works.
When evaluating an inherited investment portfolio, Amy's advice is simple: check if the investment fits your needs and how it performs against its peers. She uses direct examples to show how to approach inherited investments, considering risk tolerance and diversification.
The discussion shifts to the emotional side of inheriting investments, like stocks from a company with family loyalty. Amy suggests honoring the deceased in ways other than holding onto their investments. She proposes using the inheritance for family-oriented projects or supporting meaningful causes.
Not changing inherited investments has many risks. These include lack of diversification, mismatched risk profiles, tax inefficiencies, and altered savings needs.
On using inherited investments to support goals, Amy emphasizes clarity in goals and being aware of how they might change with new wealth. She advocates for a balance between saving for the future and enjoying the present.
Jag: Welcome back to Thimbleberry U. I'm Jon "JAG" Gay. With me as always, Amy Walls from Thimbleberry Financial. Hello, Amy.
Amy: Hello, JAG. It's fun to be talking today.
Jag: One of the things we're going to be talking about is back to the psychology of investing, and that is inheriting investments and what you do with those investments when you inherit them. There's a lot that goes into this. Where do we start when it comes to inheriting investments?
Amy: I think to lay some groundwork for our listeners today, what I'd like to focus on in this conversation is actual investments versus account types. There's a lot of talk about account types, and if you inherit an IRA or a Roth IRA, you have, in most cases, 10 years to take the money. There are all sorts of nuances there. That's not so much what I want to get into, but it's the actual holdings inside the account that I don't think get as much attention.
Jag: A lot can be tied to the psychology of, "Mom or dad was invested in this. I just want to keep that investment." We'll touch on that a little bit later on. Let's back up first and talk about the tax implications of inheriting investments.
Amy: Really easily, since I said I don't really want to talk a lot about account types, we have to touch on this. If someone inherits an IRA, a traditional IRA, a SEP IRA, et cetera, when they take money out, it is going to be taxable income. A Roth IRA should be tax-free. Other types of accounts, like a brokerage account, a taxable account, a non-qualified account, those are all the same things, have what's called a step-up in basis on the investments. There's no shell account to protect from taxes.
JAG, let's use an example where you invest $50,000 in stock ABC. That $50,000 is what's considered your basis. Typically someone's taxed on any growth from their basis to when they sell. That's what a capital gain is. Several years later in scenario one, you sell the stock for $75,000. You would pay gains on the $25,000 that occurred. You bought for 50, you sold for 75.
Jag: I'm paying capital gains taxes on the $25,000 that it gained in value from where I started.
Amy: Correct. Now the scenario, you don't sell the stock-- you still bought it for $50,000. You don't sell the stock and you pass away and it's worth $75,000 and you've named me as your beneficiary.
Jag: That's presumptuous of you, but okay.
Amy: [laughs] It's just for example's sake.
Jag: [laughs] Okay, got it.
Amy: Now there's still a $25,000 gain, but the IRS allows me to take the value on the date of your death, $75,000, as my basis, and nobody pays taxes on the $25,000 gain.
Jag: My 50 is now your 75 and you're not taxed on the difference.
Amy: Correct. Okay.
Jag: Step up in basis is something that's always confused me, and I think you've just explained it better than anyone ever has, so thank you.
Amy: You are welcome.
Jag: Okay. Numbers aside, let's go step back a little bit. How should someone evaluate their inherited investment portfolio? This goes back to what you want to talk about more with specific stocks and specific holdings as opposed to just the types of accounts.
Amy: Yes. I don't think it's any different from the way they evaluate their investments in general because these investments are now yours. To me, there are two questions. There's a process. I'm process oriented. There is a process to doing this evaluation. The first question to ask is, does this holding, meaning investment, fit me and the allocation I need, the allocation that's appropriate for me and that I'm comfortable with? Does it fit? If the answer to that is no, it needs to go.
If the answer is yes, then we have a follow-up question, and that is, how is this investment doing compared to its peers? If it's not doing well compared to its peers, and that just doesn't mean at this exact moment in time, it's evaluated over a period of time, then it's probably not worth keeping. If it's doing as well as or better, top half kind of thing, then it's worth considering keeping.
Jag: Those are important questions. Like you said, process oriented; that's a good way to look at it. Can you give us some examples of how this might play out?
Amy: Yes. Let's go with example A. I seem to like the alphabet today, stock ABC and we'll go with example A. Let's say you inherit some money and not cash. You inherit some investments. In your portfolio in general, before we even look at the inheritance, you're overweighted in international stocks. Now we add in this inherited portfolio, and it also contains a fair amount of international stocks. What we can say in this scenario, if we ask that first question, does it fit me and my allocation, is having this whole plethora of international doesn't work.
Then it's going to come to the second question of looking at the international and what's right, what fits, what's doing best against its peers? We've got a, "Does it fit me and my allocation?" It's not a clear yes or no. You need some international. Here's the amount that's appropriate to need. You already needed to shave some down. Of the international you held and the international you've now inherited, do you want to keep any of it or only part of it? That's the second question. Is any of it the right international to keep?
Let's go through example B. Let's say you're moderately aggressive in terms of risk and you inherit a million dollars of large-cap value stocks. So these are large companies, tend to be stable, that pay dividends, typically thought of as the most stable of the stocks. Having large cap value is very appropriate for someone who is moderate aggressive in terms of risk.
The question becomes, how much large cap value do you need? You got a million dollars. How big is the rest of the portfolio? What percentage of the portfolio is now in large cap value? Does that work or does it not? Let's say you need 20% in large cap value and you now have 80%. Definitely a lot of it needs to be gotten rid of and diversified other places. Then it's looking at the individual holdings once that to say, well, which of these do I want to keep, or do I want to keep any of them? Maybe there's a different large cap value holding that is more appropriate.
Jag: I'm going to draw a parallel here, Amy. Something we've talked about in previous episodes is rebalancing. If something in your portfolio does really well, selling off some of that so you can keep similar allocations percentage-wise so you're not overweighted in one particular area, this is sort of the same thing. You're inheriting these holdings and now you might be overweighted in one area that you don't want to put all your proverbial eggs in one basket. That might be where you have to start evaluating certain holdings saying, what do I keep? What do I get rid of?
Amy: Absolutely. I think with what you just said, JAG, the thing our listeners would want to keep in mind, too, is that in many cases who we're inheriting from is someone older than us, and so their risk profile is potentially very different from our own because their timeline was shorter. Just because of then where they were in life, they very likely could be much more conservative.
Jag: Sure. If they're closer to retirement and don't want to risk losing in sequence of returns and all that as they get close to retirement, they might be more conservative, whereas if you're younger, you might have time to be more aggressive because you've got time to make up anything that might happen before your retirement.
Amy: Exactly. If we're going to bring the portfolio and hold it, we're really skewing the appropriate risk tolerance for ourselves.
Jag: Makes sense. I teased this earlier. Let me turn to the emotional piece of it. As our listeners may remember, I'm here in Detroit. The Detroit Three automakers are really big here. There are folks who have, one, two, three generations that work at the same automaker here in Detroit. Say you lose a parent or a grandparent and they are loyal to one of those three auto companies. They have a lot of stock in those companies. When you inherit an investment, is there any consideration to keeping them as they are in a way to sort of honor the deceased, feeling close to that parent or that grandparent that was really loyal to that particular company? What's your thought there? I know this gets a little tricky.
Amy: It does, and I'm glad you asked the question. I think honoring the deceased when there's a gift like this, that's a lovely, wonderful thing to do.
Jag: But does it make sense?
Amy: Yes, does it make sense? I think there is almost always a way you can honor them. Does it make sense to do it by holding the stock? That's a perhaps. If keeping that stock, a portion of it or all of it fits with your goals and profile, not the stock itself, but the type of stock and the allocation that it is, and it's doing well compared to its peers, well, then, sure, you can keep it. If it's not, then you could sell and diversify, but I think the thing that's at the heart of your question is about honoring the deceased. Sometimes, just like we've talked about bias in the past, there can be a tendency, for example, if someone has a million dollars and it goes down to $800,000 because of market declines overall and they needed to rebalance, they may not want to do that until it gets back to a million dollars.
Jag: Or hope that it gets back to a million dollars.
Amy: They've attached this dollar figure to the investments that may not be realistic. The same thing can often happen with inheritance. Someone passing away, it's emotional. If they gave you a gift of a lot of money in the form of investments, most people are going to make some sort of emotional connection to that investment.
I think the trick here is to find a way to honor their memory in a different way. It's to transition this so then you're not using your bias. All families have different values. Everybody can agree on that.
I think we could agree that while this may not be the same case, we all hope it's the case that the person who left you the money cared about you enough to name you as the beneficiary. They did that wanting the best for you. Now, they may have different ideas about what the best is, but just because they've passed away doesn't mean you have to embrace their view of what best is. To me, them wanting the best for someone means that they want me to do-- if it's me, they want me to do what's right for me and my family. That means what I think is best. They would understand that me following exactly in their footsteps may not be the best thing for me and my family.
My husband and I had a date night last night. We were talking about our kids. My seven-year-old had a serious conversation with my husband and told him that he is afraid that he might disappoint me by not becoming a financial advisor [laughter] and didn't know how to break it to me. My husband took it seriously and we both giggled about it and talked about ways to reassure him that I am not expecting him to become a financial advisor.
It's that idea. The fact of the matter is, in inheriting money or saving money is a tool. That's all money is. It's a tool. If we take a step away from money for a second, let's talk about jewelry. We use money to buy jewelry, but let's talk about jewelry. I don't know if you've noticed, but even in the British royal family, there's lots of history, lots of attachment to jewels and what they were worn for.
Jag: They call them the crown jewels for a reason.
Amy: They take the jewels and they change them.
Jag: I didn't know that.
Amy: When someone inherits them, they sometimes wear them the way they were, even when it was historic, but they also regularly take them and change them to fit their personality, their style, the size. Someone smaller has a harder time wearing huge jewelry. So they're changing it over time. I think that we can do the same thing with money, so ways that we can create and honor that person, and we've definitely heard in the news, hey, she's wearing this. If we think about Princess Kate, this is a way, it's a tribute to Princess Diana, even though the jewelry's been changed.
Someone could honor the deceased by helping family. Maybe it's taking some of this money, fitting into their own financial plan, but they also find and more consciously, intentionally choose to help others more, whether that's through direct family, maybe that's through giving to charity, maybe charity that the deceased loved.
I think another example, and we have clients that have also done this, and I think it's just lovely, is they take some of the money to create a memory-making place. Maybe that's by buying a beach house or a lake house or a place that their family can be together, and they make the person who gave the money at their passing a way to live through that. Maybe it's a picture of them, or there they tell a lot of stories and incorporate them so that person and that location become entwined.
Jag: I've got a really big smile on my face right now thinking about that because that's really sweet. It's quite literally the house that grandma or grandpa built, right?
Amy: Absolutely. They aren't here to see it, but gosh, it can pull at the heartstrings, and I've got a huge smile on my face, too.
Jag: You feel like they're there in spirit, yes. Let's pull back from the emotional. We talked about how important it is to really evaluate this money when you inherit it. Let's be honest. There are some risks associated with keeping these inherited investments unchanged.
Amy: Absolutely. There's lack of diversification. We've alluded to that throughout our conversation today. Not being diversified is dangerous. It increases risk. That means that there's a greater potential that you'll have less money at the time you need it. You're going to have more ups and downs to weather or tolerate, stomach, however you want to say it. The risk tolerance of the overall portfolio is inappropriate. Whether that is you're moderate-aggressive, or aggressive and the person you inherited from was conservative, now you're maybe moderate, moderate-conservative, depending on how the numbers play out.
That's one way, but what about the opposite way, too, where maybe you're moderately conservative and moderate, and that person who passed away is aggressive?
Jag: Sure. Maybe this is sort of like play money for them and they could afford to be more aggressive because they were financially secure in other areas.
Amy: Absolutely. It can be dangerous. The portfolio may not be tax efficient. When we're talking about these brokerage accounts, not inside an umbrella of a retirement account, there's taxes being generated each year. A diversified portfolio in US equities generates a tax bill each year on average of about 2% of that portfolio's value, meaning that's what you're going to pay at tax time if it's rebalanced and taken care of. It's important to look at what kinds of investments you have in that arena and/or what the strategy is for helping minimize taxes while staying within the risk profile that's appropriate for you.
Another thing that we often don't think about is the money that was inherited can change the savings needs. Obviously, if you've got more money, you may not need to save as much, but what I'm talking about goes back to our very first podcast with the three different ways that you can save money. If all of the sudden you have more money in one area, it might mean that where you were saving on a regular basis needs to change. It may no longer be appropriate, and so continuing to save in exactly the way you did before may not be the right thing to do. You may be overweighting yourself in one of the savings areas.
Jag: All fair points. I don't want to end this on a down note, Amy, so let me flip it around. How can inherited investments support someone's goals?
Amy: JAG, I tend to come back to purpose a lot, so be clear about your goals. It's really easy when a large gift comes in for goals to change or shift. It's kind of like, and we've talked about this before, getting a tax refund. Tax refunds tend to be spent multiple times. If you're already clear about your goals, one of my questions to clients when I hear this is, well, when did your goals change? When I start to hear there's new goals. Is it a result of this money? If so, let's look at carving some of this off and putting it towards X.
You've just added, in some cases I've seen, "Oh, we're going to buy a second home, we're going to pay for grad school for the kids, and we want an earlier retirement." These were all goals before when they're all fairly new and the money's more than been spent by the cost of these additional goals. Knowing what your goals are and really honestly evaluating, what were my goals before and what are my goals now, and see where the two shall meet.
I think it's important to think about that you can split the purpose. Some money can be for the future and some money can be for today. If you didn't have it before, then you were going to need to save the money. There isn't anything that says, when you receive an inheritance, it all has to go to tomorrow. I think that's valuable to remember because I also think that a lot of times people think that's what many advisors are going to say, "Save it all."
Jag: Yes, "Save it, save it, save it, save it," but there's “fun money.” We've talked about that in previous episodes too. There's doing things that make you happy because staying in a good mental place is so important so that you can have a clear head to plan your future and do all the other things in your life. I think that's a really important point.
Amy: It's all about balance. We don't know what tomorrow brings. We want to plan for tomorrow but also enjoy today. We just have to figure out the right way to do it.
Jag: That is a great place to leave it. If anybody wants to come talk to you, Amy, and you and your team at Thimbleberry Financial, how do they best find you?
Amy: They can reach us at thimbleberryfinancial.com or by giving us a call at 503-610-6510.
Jag: Great stuff as always, Amy. We'll talk again soon.
Amy: Sounds great. Thanks, JAG.