8 Inherited Assets and How They Impact College Financial Aid

When you inherit financial assets, they can potentially have a hugely negative impact on college financial aid. Inherited assets will potentially increase your income and the value of your financial assets, and this will likely lower or eliminate your financial aid eligibility.

This is why it’s so important to understand the types of assets you’ve inherited, how they impact financial aid, and how to minimize that negative impact by managing your assets more effectively.

In this article, we’ll take a look at the eight types of inherited assets, how they affect financial aid eligibility, and the smart strategies you can use to help you minimize any negative impact on college.

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The Challenge with Inherited Assets and College Financial Aid

Here is a quick breakout out the eight types of inherited assets, divided into two main categories:

Retirement Assets

1. Traditional IRAs and 401Ks, 403bs, and 457s
2. Roth IRAs and Roth 401Ks, Roth 403bs, and Roth 457s
3. Annuities

Other Non-Retirement Assets

4. Investments (such as stocks, bonds, mutual funds)
5. Real estate
6. Bank accounts and CDs
7. Life insurance proceeds
8. College savings plans

Inherited retirement and non-retirement assets can have a potentially negative impact on financial aid because they can increase your income and financial assets during the years when you’re applying for aid. When a student submits the Free Application for Federal Student Aid (FAFSA) or completes the CSS Profile to apply for college financial aid, typically the student and both parents must report their income and financial assets. If any of them have inherited money, that will potentially reduce the student’s eligibility for federal student aid.

This is why it’s so important to understand each type of inherited asset, how it might impact college aid, and what you can potentially do to manage your inheritance so you avoid some or all of the drawbacks.

Let’s start by taking a look at inherited retirement assets.

Inherited Retirement Assets

Retirement assets generate a lot of income when you withdraw money from the accounts you inherit, and this means you’ll have to report that increased income on college financial aid applications. In turn, this will potentially reduce or eliminate your aid eligibility.

Also, with most non-Roth retirement assets, the original owner probably didn’t pay a lot of taxes on at least a portion of that money. So, when you take the money out as a beneficiary, you’ll have to pay the taxes that were deferred. So, in addition to the withdrawals lowering your college financial aid eligibility by increasing your income, they might also leave you with a big tax bill. On the other hand, Roth retirement assets avoid most of these tax problems, but they can still negatively impact college financial aid because your withdrawals still get reported as untaxed income on your FAFSA or other financial aid applications.

Another key consideration is whether assets are inherited by a student or a student’s parents. Student income and student financial assets are assessed at a higher rate during the financial aid application process. This is because more of the student’s finances are assumed to be available to help pay for college costs. After all, most students aren’t paying for a mortgage, utilities, a car loan, and other expenses that parents need to pay while their kids are in college. So, a lower percentage of parents’ financial resources is considered available for that purpose.

Given this difference, if a student inherits assets in their name rather than a parent’s name, it can be bad news. More of that money will be assessed as part of the financial aid process, so it will potentially lower or eliminate your financial aid eligibility. This is an important consideration when setting up an inheritance and beneficiaries.

Now that we know the two main categories of inherited assets, let’s take a look at the eight types of assets across those categories, so we can see how each one impacts college financial aid and how you can potentially minimize any negative impact.

But, first, we need to understand our options with these types of assets, which plays a huge role in whether your inheritance will impact financial aid. Let’s start by taking a look at inherited retirement assets, your options when you inherit them, how those options might impact financial aid, and how to plan and make the right moves to help avoid negative financial aid outcomes.

When you inherit a retirement asset such as an IRA, 401K, or annuity, you can’t just leave the accounts as they are, and you can’t merge or combine them with your own existing retirement accounts. Financial regulations require that you keep the inherited accounts separate and that you eventually cash them out. Typically, for most inherited accounts, you have to do this within 10 years, and you might also have to make minimum withdrawals.

Given these restrictions, you realistically only have three options, which are to cash it out, disclaim it, or roll it over.

Now, let’s take a quick look at each option and how it works.

Cash It Out.

The first option with a retirement asset is to cash it out. This means that you contact the investment firm that’s been handling the account, and you ask them to send you a check. However, cashing out a retirement account might create a big tax bill that you have to pay, and it might prevent you from taking advantage of other good financial opportunities.

Disclaim It.

As a second option, you could disclaim the asset and say that you’re not interested in claiming your share of it. This is a potentially great tool to use in cases where an asset would normally go to the student and cause a major reduction in college financial aid.

If you disclaim a retirement asset, then your share goes to the next beneficiary who was designated for each account. So, it might go to a parent, a sibling, or another beneficiary. If it goes to a parent, then less of the account’s value will be assessed as part of the student’s financial aid application, and this might help you still qualify for aid and increase the amount you receive.

If the disclaimed retirement asset goes to a sibling who’s not going to be in college during the time period when another sibling is attending college and needs to apply for aid, then the account’s value won’t need to be reported at all. The same is the case for any other beneficiary outside of the student and parent.

For example, let’s say that an inheritance has been left to two adult grandsons. One grandson, John, has just graduated from college and now has a large amount in student loans to pay off. The other grandson, Paul, is heading to college soon, and his family is planning for need-based college financial aid.

Let’s also say that the inheritance includes $100,000 in an IRA account and $100,000 in a stock portfolio. Each grandson will get an equal share of these assets, so each will get $50,000 worth of the IRA and $50,000 in stocks.

Here’s a quick visual of the situation:

Unfortunately for Paul, who’s heading to college, the stock portfolio could work against him for college financial aid because he’ll have to report the value of his inherited portion of that asset on his financial aid applications. John doesn’t have to worry about financial aid anymore, but if he withdraws the money from the IRA funds that he inherited, he’ll have to pay taxes on them.

However, if the two brothers work together and disclaim the assets they’re concerned about, then they can avoid those outcomes.

For example, if Paul disclaims his $50,000 portion of the stock portfolio and lets it go to John, then John will inherit the full $100,000 worth of stocks, and he can sell his $100,000 worth of stocks to help pay off his student loans. That could help him eliminate his student debt without having to withdraw funds from an IRA, where he’d have to pay taxes on those withdrawals.

If John disclaims his $50,000 portion of the inherited IRA, and he lets it go to Paul, then Paul inherits the full $100,000 worth of the IRA, which he won’t have to report as an asset for college financial aid. He would only have to report any withdrawals made during the tax years that will be used when he applies for financial aid. Once he rolls the IRA over into a beneficiary IRA, he has up to 10 years to make his withdrawals, so he can time them so they’re not made during the years when he’s applying for financial aid. This way, he can maximize his chances to qualify for aid and how much he’ll be awarded.

Here’s a visual of the assets and the amounts that they’re strategically disclaiming and allowing to go to each other:

Here’s a visual of the final distribution of their inherited assets, after their disclaimers:

IMPORTANT: A disclaimer must be submitted within nine months of a decedent’s date of death. The decedent is the person who has died and left an inheritance.

Before you disclaim anything, you want to know who the next beneficiary is and whether disclaiming will help you for financial aid purposes. If it will, then you need to move quickly because disclaimers must be filed within nine months of the date of death. So, you need to do your homework, put a plan together, and make your disclaimers within nine months.

Roll It Over.

The third option with an inherited retirement asset is to roll it over. For example, with a traditional IRA, 401K, 403B or 457 that you’ve inherited, you can roll it over into a beneficiary IRA. For all traditional account types, which have never had taxes withheld, these are rolled into one big beneficiary traditional IRA.

All Roth account types, including Roth IRAs, Roth 401Ks, Roth 403Bs and Roth 457s, can be rolled over into a one big beneficiary Roth IRA.

Once you roll over your inherited assets, you have more decisions to make. Next, you need to figure out how you’re going to withdraw the funds. Most of the time, you’ll need to cash out the accounts over 10 years, and you may need to make minimum withdrawals too. You have different options for how you time and structure your withdrawals, but, ultimately, after 10 years, the money needs to be gone.

In some cases, you might have some different options, if the person inheriting the asset is a spouse, a minor child, a disabled person, or is in one of the other categories covered by special rollover rules. So, it’s important to find out which rules or options apply in your case. However, most people are not in one of these special categories, so they’ll typically need to withdraw the inherited funds over 10 years and may need to make minimum withdrawals along the way.

Keep in mind that you can still decide to cash out the full amount at any point. If you change your mind, or if your financial situation changes, and it makes sense to cash out the account, you still have that option. You can cash it all out, even if you’ve rolled your inherited retirement assets into beneficiary accounts.

How Inherited Retirement Assets Impact College Financial Aid

IRAs, Roth IRAs and 401Ks

Money that you inherit may or may not be assessed as an asset for college financial aid purposes. For example, if you’ve inherited traditional IRAs or a traditional 401K, 403B, or 457, and you’ve rolled them into a beneficiary IRA, that beneficiary IRA will not be assessed as a financial asset for college financial aid purposes. In other words, colleges won’t be looking at the total value of that beneficiary IRA as something that you can use to help pay for college.

However, you will have to take out withdrawals, which will be taxable income that you have to report on your tax return. If those withdrawals take place during the tax years for your college financial aid applications, then the amounts of those withdrawals will be assessed as income for college financial aid. The withdrawals will increase your income, which will likely lower your financial aid eligibility.

If you’re dealing with a beneficiary Roth IRA, where you’ve rolled an inherited Roth IRA, Roth 401K, Roth 403B, and/or Roth 457 into it, you don’t have to pay taxes on your withdrawals. But the value of those withdrawals may still flow through your tax return, and you may have to report those amounts as untaxed income on your FAFSA or other college financial aid application. Much like taxable income, that can have a negative impact on your financial aid eligibility.

As an example, I’ve seen cases where families were planning to withdraw all their inherited Roth IRA money all at once, since it’s tax-free. But, if they withdrew all the money, it would still potentially be income that they have to report on college financial aid forms, and, if they withdrew it and deposited it into a bank account or other asset that’s assessed as part of financial aid, then they would potentially wipe out their financial aid eligibility entirely.

Hence, I advised them to strategically plan and time their withdrawals, so they would still get the benefits of their tax-free withdrawals without creating a massive increase in income or another detriment to their financial aid qualifications.

Let’s take a quick look at an example of how this can work.

Let’s say that you’ve inherited $100,000 in an inherited retirement account, and you’ve rolled it over to a beneficiary account. Let’s also say that have two or three students who will be applying for financial aid during the next 10 years, when you’ll need to make your required withdrawals.

Your best option might be to withdraw the money in roughly equal amounts across those 10 years, starting with an initial withdrawal during the current year, which is the date of the decedent’s death. So, that means you’re actually making 11 withdrawals. Doing this can help you minimize the amount of your withdrawals in any given year, which might help you minimize any negative financial aid impact during that 10-year period.

Here’s a quick view of how that kind of withdrawal plan might look, beginning with the current year, which is shown as year zero, and proceeding through the subsequent 10 years:

Annuities

Inherited annuities are relatively complicated, and there are many options for what you can do with them.

The first option with an inherited annuity is to cash it out, which is typically available in virtually any case. Secondly, you can disclaim your share of an annuity, and it will go to other heirs, similar to how disclaiming works with inherited retirement assets. But it’s important to make sure that it will go to someone you would approve of receiving it. Finally, you may have options to roll the annuity into a different type of investment.

When you inherit an annuity, usually there is a claim packet that you receive from the annuity company. It provides you with choices such as taking the money as a check, withdrawing it over five or 10 years or you’re expected lifetime, or rolling it over into different types of investments.

Not all annuity companies provide every option. Sometimes, there are options an annuity company isn’t offering to you. But you could get them if you complete a 1035 exchange, which is a transfer of the money from your current annuity to a deferred annuity with a different company.

If you do a 1035 exchange, you’ll avoid all taxes. However, there may be some surrender charges or other reasons why you might not want to do this.

For example, I recently worked with a client who would have faced huge surrender charges if we cashed out an annuity and moved it to another company. It was a $100,000 annuity, but the client would have been left with only $60,000 if the money had been moved elsewhere. So, we elected to keep it with the same company, set up a beneficiary annuity, and take withdrawals over five years. Doing this avoided any surrender fees.

However, in general, a 1035 exchange allows you to change the annuity type and potentially tap into more investment options with another company.

As with inherited retirement accounts, you can’t just take over the account and grow it as your own annuity. You still need to roll it over and maintain it as a beneficiary annuity. That means you have to do the paperwork properly. But, once you make that change, you have the option to cash it out over a period of years or your remaining estimated lifespan.

For example, you could divide it by five and withdraw it by equal amounts over five years, or you could take it out by different amounts over those five years. As long as it’s completely withdrawn by the required number of years, then you’ve met the rules and requirements.

Alternatively, you could just ask to withdraw everything all at once. Or you could disperse it over your remaining lifespan by using what’s called a stretch annuity. That allows you to withdraw the money over your own life expectancy.

Differences in How Inherited Annuities Work with College Financial Aid

One advantage with inherited annuities is that they potentially give you many options that can be beneficial for maximizing your chances of receiving college financial aid. For example, you can choose an option and plan to withdraw a minimum required distribution each year, which totals a relatively small amount. But you would still have the option to take out more, if needed. So, in certain years, you could withdraw more money but then revert back to taking only the minimum required distributions.

You can use these kinds of options to help you plan around college and financial aid, so you take out more money to help pay for college but carefully plan your withdrawals, so you don’t generate extra income that could work against you for financial aid purposes. You can also time some of your withdrawals to occur before the first tax year and the subsequent tax years that will be used when your student applies for college financial aid, so your withdrawals don’t generate huge increases in income during those pivotal years. But, yet, you can still withdraw some of the money to help you pay for college.

Generally, annuities are not considered an asset on the FAFSA, so you don’t have to report their full value. But your withdrawals or portions of them will be taxable, and they’ll potentially generate income that you’ll have to report on financial aid applications. Hence, this is why planning, scheduling and timing your annuity withdrawals is so important. Regardless of whether it’s taxable income or not, the FAFSA will take the income into account anyway.

Inherited Non-Retirement Assets

There are four categories of inherited non-retirement assets:

• Real estate
• Bank accounts and CDs
• Life insurance proceeds
• Investments

All of these things can come to us relatively tax-free. However, they do count as an asset for financial aid purposes. Thus, their value and any income they generate must be reported on your financial aid applications, and this might lower your financial aid eligibility or even reduce it to zero.

Some of these assets provide us with options similar to those we have with inherited retirement assets: you can cash them out, disclaim them, or keep them. Also, as with inherited retirement assets, the person who inherits non-retirement assets is crucial. If an asset is inherited in the name of the student rather than a parent, more of its value and more of the income it generates will be assessed as part of the financial aid application process. So, it will potentially reduce your aid eligibility more than it will if the parent inherits it.

When you inherit assets like these, you’ll also typically get a step-up in basis. This is an adjustment to an inherited asset’s fair market value on the date of the decedent’s death. It starts with the cost basis, which is the price of an asset when it was originally acquired. It’s the price for the asset, plus any related fees. The difference between this cost basis and the price when you sell the inherited asset is what determines the taxes owed.

A step-up in basis occurs when the price of an inherited asset on the date of the decedent’s death is above its original purchase price. In other words, the asset has gained in value and is now worth more. The federal tax code allows for the raising of the cost basis to the higher price, minimizing the capital gains taxes owed if the asset is later sold.

The step-up in basis applies to financial assets such as stocks, bonds and mutual funds, as well as real estate and other tangible property. Typically, an adjustment to the cost basis is a step-up because inherited assets are typically long-term holdings that have gained in value or have had positive rates of return. In the event that the price of an asset has declined from that paid by the owner’s date of death, then the cost basis would step down instead.

Hence, if we sell anything right near the date of death, many times there are minimal taxes owed. If you inherit insurance proceeds or bank accounts, there typically aren’t any taxes associated with those. This is because the original owners paid all the taxes in the case of bank accounts, and life insurance proceeds are always tax-free. So, once you receive assets like these two, you’ll typically put them into a bank account or wherever you might prefer.

If you keep non-retirement asses as they were, then they are all considered assets for college financial aid purposes. So, all of our stocks, bonds, and any real estate that isn’t our primary residence must be reported and will be assessed on financial aid applications. Colleges will consider them in play as assets you could potentially use to help pay for college.

So, the next step would be to cash them in, collect the funds, and deposit them in your own bank. Now, of course, the money is still an asset at this point, and you would still need to report it. But now you have a financial planning opportunity where you could move the money into a new investment of some sort, or move it into annuities, a 529 college savings plans, or even into better stock or bond investments than those we inherited. And those investments might be excluded from the college financial aid process or least minimize how much they might negatively impact your aid eligibility.

If you move your money into retirement investments, then it will no longer count as an asset for financial aid purposes, although any withdrawals during the tax years used for financial aid applications will be considered income. That could affect your financial aid eligibility. But moving your money in the right ways, and planning with smart strategies, can help you minimize any negative impact on college financial aid while you potentially maximize the value and growth of your money.

Of course, with a student or possibly multiple students going off to college, you may still need to use some of this money to pay for college, so you may need to keep some of it more accessible, rather than move it into investments that aren’t as easy to access and use. But you have many options, and this is where smart planning can really help you make the most of your inheritance while still maximizing your potential financial aid qualifications and award.

Finally, with 529 college savings plans, these are treated a bit differently compared to other financial assets. Any funds in a college 529 plan will certainly be assessed as part of the financial aid process, since the funds are obviously intended to help pay for college. But here is what you need to know about how 529 plans are handled when they’re inherited.

A college savings plan has a beneficiary who is typically the student who is heading off to college. It’s not necessarily the person who inherits the plan when its original owner passes away. For example, grandma might pass away, and her daughter might inherit the plan, but the designated beneficiary is a grandson—the mother’s son—who will use it to help pay for college.

In this case, the person who inherits the plan (mom) is a successor owner, which is separate from the beneficiary (her son).

When grandma was alive, she owned the plan, and she determined when and how to spend the money. But, now, her daughter has inherited the plan and will get to make the decisions on how to use the money and whether it will be used for college. She will need to set up a new successor owner, in case anything happens to her. That might be her spouse, her son, or someone else in the family. But, in the event that the plan passes to that successor owner, then that person has all the decision-making power over the money.

Occasionally, mom might put her son in that role, if she feels that he’s old enough and mature enough to manage the money appropriately. But, if she designates a different successor, she needs to be able to trust that person to do the same thing. Strictly speaking, the successor owner could cash out the money and use it for another purpose, even though there are fees for using a 529 plan for any expenses other than qualified education expenses. So, always be careful about who is designated as the successor owner and whether you designate the beneficiary for that role.

Key Takeaways and Taking Your Next Steps with Your Inheritance

Hopefully, this article has helped you get a much better understanding of how inherited assets can impact college financial aid. When you inherit assets, you have many options, and what you do with those options and with your assets can have a negative or a positive impact on college financial aid.

If you want to maximize your aid eligibility, minimize any potential negative impact, and make the most of your inheritance, then you need to understand your assets and options, and start planning as early as possible.

With the right plan, you can make smart moves such as rolling over or converting your assets, timing your required withdrawals, and using other available options to maximize the benefits of your inheritance while you also maximize your college financial aid eligibility and hopefully keep and put more of your inherited assets to the best use for you and your family.

The best place to start is to reach out to a Certified Financial Planner® and advisor who has deep experience with inheritance, college, retirement, and all aspects of financial planning. As a Certified Financial Planner and a specialist in college planning, retirement, and inheritance for over 20 years, I’m certainly happy to help, and we can start with a free consultation, to help you learn more and determine your next steps.

I’ve helped many clients develop a winning financial plan for their inheritance, college, retirement, and all their personal goals. And I’d be glad to review any assets that you’ve inherited or expect to inherit, to help you determine your best options and explore the best ways to manage your money and successfully plan and pay for college at the same time.

To get started, feel free to set up a free online or in-person consultation with me at your convenience. You can also call my office at 414-420-4200 or contact me via email now.

Disclosures

Always remember that investments, assets and how you manage them involve risk. Please carefully consider your investments and assets and any risks, charges and expenses.

In addition to working with a Certified Financial Planner® to help manage your assets appropriately, it’s also a good idea to consult a tax professional, to make sure you understand the state and federal tax rules around how you make withdrawals on inherited assets and how you manage them.

Brad Baldridge is a Registered Representative, Securities offered through Cambridge Investment Research, Inc. a Broker/Dealer, Member FINRA / SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Fixed insurance services offered through Baldridge Wealth Management. Cambridge’s Form CRS (Customer Relationship Summary). Taming the High Cost of College, Baldridge College Solutions, and Cambridge are not affiliated. Cambridge does not provide tax or legal advice.

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