An inheritance can be a financial windfall if you’re a beneficiary, and one of the most common ways that people use money that they’ve inherited is to help pay for college costs.
However, if you’re not careful and don’t understand the assets you’re inheriting or how to manage them properly, you could end up losing a lot of money. The wrong moves can cost you tens of thousands of dollars in taxes, penalties, and reduced financial benefits, including a huge reduction in college financial aid.
However, the good news is that an inheritance can also be a huge benefit, not just because you can potentially tap into some of the money you’ve inherited to help pay for college. The right moves can help you, keep more of your money, minimize taxes, and minimize any negative impact on financial aid eligibility.
As a Certified Financial Planner® who specializes in estate planning, retirement and college planning, I’ve seen this first-hand for more than 20 years. I work with clients to help them manage and grow their financial assets so they can achieve their personal and financial goals, and I’ve helped many clients maximize the benefits of an inheritance while avoiding some of the common mistakes can reduce those benefits.
In this article, I’ll show you what can go wrong and what can go right when you have an inheritance and want to use it to help pay for college. Then I’ll show you how you can start planning and managing your inheritance the right way, so you can get the best results.
Let’s start by taking a look at a few quick examples.
What Can Go Wrong with an Inheritance and College Finances
Example #1: Trusts in a Student’s Name
It’s common for people to leave money for their heirs to help pay for future college costs. For example, Grandma might leave $100,000 in a trust for her grandson, so he can use the money to pay for college.
Of course, that $100,000 could be a huge help financially, and Grandma probably had the best of intentions in leaving it in a trust in her grandson’s name. However, when the trust is in the student’s name, there are some potentially major unexpected costs when it comes to college financial aid.
When students apply for financial aid, they have to complete the Free Application for Federal Student Aid (FAFSA) and/or the CSS Profile, and they have to provide a tax return and information on other financial assets and accounts in their name. Those assets are assessed through the FAFSA as part of financial aid eligibility, with 50% of a student’s income (above a certain amount) and 20% of a student’s financial assets considered available to help pay for college. The CSS Profile assesses student income and assets in a similar way.
Depending on how the grandson withdraws, manages, or uses the $100,000 he inherits, that money will potentially be counted as income or assessed as an asset that can be used to help pay for college. Subsequently, that could reduce the grandson’s financial aid eligibility all the way down to zero, forcing him to use all of the money for college.
In contrast, if the money had been put in a parent’s name, the results would be dramatically different. Only 47% of parental income and 5.6% of parental financial assets are assessed as part of college financial aid eligibility. Thus, if the $100,000 were kept in the right account and not withdrawn right away, it would be assessed as a financial asset at the rate of 5.6%, which could result in the grandson qualifying for financial aid and potentially much more of it. That could mean that a sizable portion of the $100,000 could still be left over after college.
Additionally, whether it’s in the student’s or parent’s name, if the money is inherited in an IRA account, and you take it all out in one big check, you have to report the money as income, which potentially lowers your financial aid eligibility even further. In contrast, if you leave the money in the IRA and withdraw it over a period of years, timed accordingly to the student’s college years, you can minimize or maybe even avoid this negative impact.
Example #2: Huge Tax Bills and Income Increases
Another big potential risk with an inheritance is that you may have to pay a huge tax bill when you withdraw some or all of the money. Taxes are inevitable with some types of inherited financial assets, such as a traditional IRA or 401K, but they’re avoidable or can be minimized with some assets or in some situations.
For example, Roth IRAs and Roth 401Ks are popular choices for investing because they’re funded with post-tax money. Since taxes have already been paid when the money is invested in these IRAs, no taxes are due when you withdraw funds from these accounts.
Even if these accounts have earned money and grown, you don’t owe any taxes on the withdrawals. This means an heir who has inherited one of these types of accounts won’t end up with a big tax bill. However, there is still one potentially negative impact, especially for college financial aid.
Both traditional and Roth IRA and 401K withdrawals still show up as income on your taxes, and a big increase in your income could significantly lower your financial aid eligibility when you submit your FAFSA or CSS Profile. Since student and parent income is assessed at a high rate for financial aid purposes, you’re potentially going to take a hit. You could qualify for much less financial aid or get none at all based on the timing of your withdrawals and when a student is in college.
Example #3: Annuity “Gotchas”
If you inherit an annuity, there are unique implications, tax treatments, and potential impacts on financial aid. Depending on the type of annuity and what you do with it, there can also be “gotchas,” such as losing out on a large monetary bonus if you decide to cash out.
For example, you might inherit a $150,000 annuity, which includes a $50,000 bonus that you don’t get if you cash it out. If you decide to take all the money now, you won’t get the bonus and will only get $100,000. If that extra $50,000 was needed for college, and now it’s lost, you could end up needing to borrow student loans or pay way more out of pocket. However, if you withdraw payments over a five-year period, you could potentially get the full $150,000, plus a tiny bit of interest.
Many people who inherit an annuity aren’t aware of these important details and all the potential “gotchas,” so they don’t make the right moves and cost themselves a lot of money.
Example #4: Bad Timing and Poor Planning of Withdrawals
Unfortunately, with inherited traditional IRAs and Roth IRAs, you can’t combine these funds into your own IRAs. You can cash them out and get a check, or you can keep them as inherited assets for up to 10 years. Eventually, you have to withdraw all the money.
You also have to withdraw all the money from an IRA or Roth IRA by the end of the 10th year. This means that the timing and amount of your withdrawals is extremely important, especially if you have a student who will be in college at any point during those 10 years. If you withdraw the money during the years when your student is in college, it will be counted as income on your taxes and also for financial aid purposes. As we discussed earlier, this can significantly decrease your financial aid eligibility.
To minimize the negative impact on financial aid while your student is in college, you could make your withdrawals on the IRA before and after your student is in college, so the money doesn’t show up as income during the tax years that are assessed for financial aid. Once they’re applying for financial aid, you can take out smaller amounts or stop your withdrawals, so your income is lower for financial aid purposes during your student’s college years.
Alternatively, you could backload your withdrawals toward the end of your 10-year withdrawal period. For example, during the first few years, you limit your withdrawals to $5,000 per year, to help with college, but not cause such a big hit to financial aid. Then, you could withdraw the remaining in the final years of the 10-year period, after your student has completed college.
How to Avoid Inheritance Mistakes and Make the Most of Your Money
If you’re about to inherit money and assets, or you’re expecting to do so in the future, there are a few basic things you need to do. Following these steps will help you maximize your potential benefits and avoid mistakes and potentially huge financial costs.
1. Take inventory of your inheritance.
Start by taking inventory of what you’ve inherited or what you expect to inherit in the future. Does it involve money in the bank, IRAs, annuities, stocks, a house, or other types of assets?
2. Separate the assets by type, and assess their potential impact.
Learn about the rules, laws, tax treatments, and financial implications of each asset type. Make sure you understand what will happen if you withdraw the money, sell the asset, move it into another investment, or manage and use it in different ways.
3. Understand the impact of your inherited assets on college.
If you’re considering using some or all of the inherited money to help pay for college, make sure you understand how each asset could impact your income, taxes, and resulting financial aid eligibility. Determine whether you’re better off using some of the money for college or better off keeping, saving, or investing it for other purposes.
Additionally, explore strategies to help you manage the money wisely, so you can minimize taxes and costs, keep more of your money, shield it from financial aid assessment, and minimize the negative impact on college
4. Talk to an expert.
Understanding inherited assets and figuring out the best ways to manage them is a big task. It takes time, research, and effort, and you can easily spend weeks learning everything you need to know.
If you’re a do-it-yourself kind of person and love that kind of challenge, then it’s time to get to work. But, if you’d prefer to speak to a trusted expert and get advice from a certified financial professional, it makes the most sense to speak with a financial advisor. Ideally, you should reach out to a financial planner who also understands college as well.
As a Certified Financial Planner® and as an expert in inheritance, financial planning, retirement, and college funding, I’d be happy to help you. We can review your situation, the assets you’ve inherited or expect to inherit, and determine the next steps you should take and your best options. If you’d like further assistance, we can also discuss how you can work with me to help you manage your inheritance, so you can maximize your benefits.
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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