FAQ -- investing an inheritance

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Inheriting is a whole new world for most of us. Here are some frequently asked questions about investing and inheritances with answers from Bankrate.com experts Dr. Don and the Dollar Diva.

What is the best way to defer paying tax an IRA my brother and I inherited from our mother?

I recently received a $10,000 inheritance and need help deciding how to invest it.

My wife died this year with several stocks held in her trust, with me as the beneficiary of the trust. What would the cost basis of those stocks if I were to sell them?

I received an inheritance that is about the same amount as my outstanding mortgage balance. Should I pay off my mortgage and invest my monthly mortgage payments, or should I invest the entire lump sum?

What is the best way to defer paying tax an IRA my brother and I inherited from our mother?

When a spouse inherits an IRA, he can roll it over into an IRA of his own. Unfortunately, sons and daughters do not have that option; they have to take distributions and pay tax on them. However, you won't pay early withdrawal penalties for taking these distributions before age 59-1/2.

Your mother's IRA documents and the Internal Revenue Service regulations determine how you can receive the money. If the IRA allows it, the best way to defer taxes on your inheritance is to elect to spread the distributions out over the longest period available to you. The rules are complicated, but knowing that your mother was more than 70-1/2 when she died, there are some general guidelines. First, you need to know what method your mother used to calculate her life expectancy for her IRA distributions: term-certain or recalculation.

Term-certain: With this method, life expectancy is estimated from the tables provided in IRS Publication 590, Individual Retirement Arrangements, and the IRA account balance is divided by the life expectancy to determine the first year's distribution. Each subsequent year, this estimated life expectancy is reduced by one year to provide the denominator for calculating the annual distribution. For example, if the table estimates a life expectancy of 20 years and the IRA balance is $400,000, the first year's distributions would have to total $20,000. The next year, the remaining balance would be divided by 19, the following year by 18.

If this method were used and you were a designated beneficiary, distributions can be made over the joint life expectancy of your mother and either you or your brother. (When more than one beneficiary is on the account, the life expectancy of the eldest is used.) This will be a much longer period than if you had inherited the IRA as a beneficiary of her estate and distributions had to be made over your mother's shorter life expectancy.

Designated beneficiary means your mother named you and your brother as beneficiaries on her IRA account. Otherwise you would have inherited the IRA as a beneficiary of her estate.

Recalculation: With this method, the tables in the IRS Publication 590 would have been checked each year to determine her new life expectancy, and her IRA balance would have been divided by that number to determine the annual distribution amount.

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The upside of this method is that the payments are stretched out over a longer period of time. The downside is if you were not designated as a beneficiary, you would have to take the entire distribution by Dec. 31 of the year following your mother's death. I hope you are a designated beneficiary so you can stretch distributions out over your life expectancy and enjoy some tax deferral.

The rules are complex. For specific information, look at IRS Publication 590; get a copy of the IRA document, and talk to the IRA administrator to see what your options are and what will work best for you.

I recently received a $10,000 inheritance and need help deciding how to invest it.

Ask yourself what personal goal you want to work toward and that will help you decide how to invest the money. Most investors want two things from their investments: to get back what they originally invested (principal) and to earn a return on their investment that increases the purchasing power of the invested principal.

The further away the goal, the more money you should have in stocks. Stocks have a track record of returning more than bonds or money market investments when investing for the long haul. If you are saving for retirement and retirement is 15 years to 25 years away, then choose a no-load mutual fund that invests in a broad-based market index of stocks.

If your financial goal isn't quite so far away, you should have more of the money in bonds. Bonds are often called fixed-income investments because the return on the investment is contractual, or fixed. As long as the company meets the terms of the bond agreement, the investor will be paid the interest and principal payments on the bond. Default is possible with corporate or municipal debt. U.S. Treasury securities have no risk of default. I like buying individual bonds or CDs vs. a bond mutual fund, but a mutual fund will spread any default risk over more issuers.

Invest in money market mutual funds (or MMF, for short) when you expect that you will need the money within a year or so of investing the funds. MMF investments are very safe, and it's highly unlikely that you would lose any principal. These investments are easily converted to cash. Many MMFs allow the investor to write checks against the balances in the fund.

So, the shorter the investment horizon, the less risk you should take with your investment. But try not to look at the inheritance by itself. What percent of your total investment portfolio does this represent? How will that change over time? How likely is it that you will have to sell the investment to meet some unanticipated future need? If you expect pension, Social Security and 401(k) money will pay for your retirement, then you shouldn't invest the inheritance for that horizon.

My wife died this year with several stocks held in her trust, with me as the beneficiary of the trust. What would the cost basis of those stocks if I were to sell them?

The basis is the amount you would report on your individual tax return as the "cost" when you sell the stock. There are two possibilities:

Stepped-up or stepped-down basis: The amount you report as "cost" is the market value of the stock at the date of your wife's death.

This generally occurs when stock is inherited, and the value of the stock is included in the decedent's estate for estate tax purposes even if no estate taxes are required.

Carried-over basis: The amount your wife would have reported as "cost" if she had lived is the same amount you would report as "cost" when you sell the stock.

Carried-over basis usually occurs when stock is received as a gift. It can also occur when inherited stock is not included in the decedent's estate for estate tax purposes because, for example, the decedent had only a life income interest in the trust and never personally owned the stocks.

Ron Aucutt, an estate tax attorney with McGuire, Woods, Battle & Boothe LLP, in McLean, Va., says he would need to know what kind of trust your wife had to determine the stock basis. He's suggesting two possible scenarios:

1. The stock will have a stepped-up or stepped-down basis if the trust is a revocable living trust with the following characteristics:

The trust is set up by your wife, who is the beneficiary until her death.
You become the remainder beneficiary, or you receive the stock outright when she dies.
The value of the stock is included in her estate for estate tax purposes, even though there will be no estate tax due on the stocks passed on to you.
There is an exception: If any of the stocks in the trust were given to her by you within one year of her death, the basis of those stocks would be carried-over.

2. The stock will have a carried-over basis if the trust had the following characteristics:

The trust was set up by someone else, perhaps her parent.
Your wife is the beneficiary until her death.
You become the remainder beneficiary, or you receive the stock outright when she dies.
The value of the stock is not included in her estate for estate tax purposes.

The stepped-up feature of appreciated stocks makes them a sweet way to remember your loved ones when you die.

Let's say the inheritance is $205,000 and so is your mortgage balance. Let's also say that you have a 30-year fixed-rate mortgage at 8 percent, with a payment of $1,500 per month and a full 30 years to run. If you keep the mortgage, you'll pay a total of $540,000 with $335,000 of that being mortgage interest expense. The interest expense will save you about $110,550 in federal income taxes (at the 33 percent marginal tax rate). You can invest the $205,000 and it will be worth about $2,242,000 30 years from now, assuming an 8 percent annual after-tax return, compounded monthly.

If you pay off the balance and invest $1,500 monthly, at the end of 30 years the investment will be worth about $2,250,000; again, assuming an 8 percent annual after-tax return, compounded monthly. But you'll have paid an additional $110,550 in federal income tax over the years due to the loss of the mortgage interest deduction.

The portfolio values are close enough that the decision really hangs on the tax benefit. The portfolios are $8,000 apart and most of that difference is attributable to rounding. I'd chose to invest the lump sum. It gives you financial flexibility that you may need down the road and allows you to keep the tax deduction. The tax savings could be invested over the years to add to the value of the portfolio. Assuming that you'd receive the same tax benefit each year, invest that at 8 percent after-tax, compounded annually, and the tax savings are worth $417,000 at the end of 30 years.

-- Posted:Aug. 7, 2001