What to do with Windfall
Sometimes a windfall or influx of cash is expected, such as the sale of a business or property. Other times, it can be very unexpected, such as the death of a family member (inheritance). Either way, these events oftentimes carry other responsibilities or items of consideration that compete for your attention, which can result in a non-tactical approach in terms of how to manage that influx of cash. During an event like this, a few things can help you manage the windfall prudently.
- Create a holdback for taxes
- Review opportunities to step up the cost basis
- Review risks, including concentration risk
- Review separate or community property considerations
- Build a strategy to reinvest
Create a Holdback for Taxes
In some instances, a tax holdback may not be necessary. If the windfall was generated from the sale of your home (primary residence) you may qualify to exclude up to $250,000 or $500,000 (married filing jointly) of the gain on the sale of your home. To qualify for this exclusion, you must meet several requirements, including owning your home for at least two of the last five years and living in it for at least two of the last five years. If, however, you sold another piece of property that did not meet these requirements and you realized a capital gain in the process, you will very likely owe taxes on that gain. Work with a qualified accountant to estimate the taxes owed and set aside that amount in a riskless investment (i.e., a money market account, CD, etc.) so the money is there when the tax bill arrives. If the windfall came from an inheritance, different considerations may apply. Generally, if an estate is less than $15 million or $30 million (married), then estate taxes would not be a concern. However, during the course of the estate administration process, the assets in the estate may continue to generate income. If the Executor distributes those assets to the beneficiaries before the estate pays the tax liability, those liabilities usually flow through to the beneficiary. It is therefore prudent to remain in close communication with the Executor and the estate’s accountant to determine what, if any, taxes may be owed prior to reinvesting those assets. If taxes are anticipated, it is recommended to retain enough in money market or CDs to cover that tax liability. Once all taxes are paid, you can reinvest any remaining cash according to a longer-term strategy.
Review Opportunities for a Step-Up in Cost Basis
Under current law, it is most often the case that any assets owned outright (i.e., not in an irrevocable trust or other similar vehicle) by the decedent would receive a step-up in cost basis. The Executor must ensure that assets in the probate estate receive a step-up in cost basis, bringing the cost basis up to the asset's market value as of the decedent’s date of death. As a beneficiary, it can be prudent to ask the Executor and review statements to ensure the step-up has been completed before selling any inherited investments. This process has proven extremely beneficial for heirs who inherit investments that are not held in irrevocable trusts or retirement accounts (i.e., real property such as ranch land or financial property like a brokerage account). In a perfect world (where the basis is stepped up and immediately handed to the beneficiary), the heir could sell the asset(s) without realizing any capital gain. This is especially beneficial if the decedent owns property with a very low basis that would otherwise generate significant capital gains taxes.
Review Risks
If you inherit, review the assets for potential risks and work to reduce them when possible. This could include reviewing real property to ensure there are no environmental hazards and making sure the property is appropriately insured. It could also be an investment portfolio with a concentrated position (i.e., a position in one firm that comprises more than 10% of the overall portfolio). The step-up in basis (above) gives the heir flexibility in terms of de-risking the portfolio, at least insofar as tax considerations are concerned. The beneficiary of the estate could sell or trim that concentrated position to bring it down to 10% or less of the portfolio, without realizing a high capital gain on the sale. Whatever the risks, work with a qualified insurance professional, accountant, attorney, and financial advisor to ensure risks are reviewed and mitigated within reason.
Review Separate or Community Property Considerations
Separate property laws can vary by state in the U.S. In Texas, the sale of a business would likely be considered community property if that business was established and grown during the marriage, so any proceeds from that sale would be divided between spouses in the event of a divorce. An inheritance, even during the marriage, would usually qualify as separate property, meaning it would not be divided in a divorce. That said, you must provide clear and convincing evidence that the inheritance was and remains separate property. One of the cleanest ways to maintain the inherited property as separate property is to allocate investments or cash to an account that is titled in the individual heir’s name with the description: “Separate Property.” (For example, the investments could be allocated to an account titled: “Jane Doe Separate Property Investments.” Once the account is funded, avoid commingling community property cash or investments into that account. Additionally, while the principal itself may be separate property, that principal can (and usually does) generate income after it has been inherited. That income, because it is produced during the marriage, would not retain the separate property character of the principal. If the income is reinvested with the principal, it can cloud the property’s separate property status. One simple solution to avoid this commingling of income is for your asset management firm to establish a separate account or portfolio in which all the income (dividends, interest, etc.) is accumulated and held in cash or a money market. Then, periodically, you can distribute that cash accumulation to a joint account (community property), where it can be reinvested along with other community property.
Build a Strategy to Reinvest
Many business owners are experts in their field and have devoted their professional lives to understanding the intricacies of their business. However, they may not have had time during that journey to develop a high level of acumen in investment management or financial planning. Similarly, unless you have worked in the field, it can be difficult for an heir to know what to do with a windfall of cash from a family member’s estate, including how to invest those dollars. Additionally, many estate Executors will distribute securities (i.e., stocks and bonds) in-kind to an estate beneficiary, which adds to the confusion. Even though the investment strategy (allocation by asset class plus security selection) may have been appropriate for the decedent, that does not mean that the investment strategy is appropriate for the heir. While there is a common perception that the elderly should be invested more conservatively and younger investors more aggressively, that is not always the case. A good financial advisor will build a strategy based on factors that extend well beyond the client's age. There are many elderly investors who have the ability to invest more aggressively because of more certainty (shorter time horizon) and income from other sources (i.e., a pension), and there are younger heirs who may need to invest more conservatively (perhaps they are about to make a large purchase or experience a transition in employment that would warrant more caution). Regardless of the situation, it is almost always the wrong answer to hold an inherited investment portfolio as it was before it was passed down, without any further strategic review. Work with a qualified advisor to ensure short-term needs are covered through less volatile asset classes, while longer-term dollars are allocated more aggressively to achieve the growth needed to reach and fund those goals. For retirement accounts (i.e., 401(k)s or IRAs), a shift in investment strategy within the account can be easily accomplished without creating a taxable event. Even for assets held in a taxable account, it may be a painless adjustment since those assets most likely received a step-up in basis (see above) as of the date of the decedent’s death. During this adjustment process, it is important not only to consider non-discretionary short-term and long-term goals (i.e., paying for education or funding retirement), but also to review any discretionary goals the windfall would make possible. For example, perhaps you have been dreaming of taking the family on an overseas trip or upgrading to a new home. These “quality of life” goals may be possible to pursue, as long as they are viewed in the context of the non-discretionary spending goals. A qualified advisor can help by analyzing needs and wants to determine whether pursuing discretionary spending plans would substantially increase the risk of falling short of non-discretionary goals.
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