Coming into substantial wealth—whether through an inheritance, business sale, large severance package or other means—can mean a lifetime of financial security and the freedom to pursue your dreams. But failure to manage a windfall wisely can lead to deep regrets. About 70% of wealthy families lose their wealth by the second generation, and 90% do so by the following generation.1 The key to making sudden wealth count is to look ahead and plan wisely.
Following are some wealth planning considerations for those who just got a lot wealthier or expect to be soon.
Rethinking Your Asset Allocation
The mix of investments you own reflects your goals, your tolerance for risk and your investing time horizon. Coming into a large sum of money often changes the assumptions behind your asset allocation. You might choose to retire early, fund your kids’ or grandkids’ educations or splurge on a vacation home. All the new variables will need to be plugged into your investment plan to assure that you can comfortably fund your goals while remaining financially secure over your lifetime. Recipients of windfalls often find their appetite for risk changing. With more money to invest, some choose to dial down the risk in their portfolio because their goals are largely covered. Others may feel emboldened to get more aggressive with a portion of their portfolios. Of course, you’ll need ample cash or liquid investments to pay for short-term expenses. One of those expenses may be taxes due on your new money. As with any life event, it’s important to meet with your wealth advisor when your financial picture changes.
Paying the Tax Man
Some windfalls come with a tax bill, while others do not. Lottery winnings, for example, are taxed as income, at a top current rate of 37%. Also, a windfall could push you into a higher tax bracket. Inheritances, on the other hand, are not considered income. They may be subject to estate tax at the federal and state levels, however. Estate taxes come into play on the value of the benefactor’s estate that exceeds $12.06 million, or $24.12 million for a married couple, with the top tax rate at 40% in 2022.2 Seventeen states have an estate or inheritance tax.3 Planning to cash out your stock options? If you make a profit, prepare for a capital gains tax bill.
When You Inherit Investments
If you inherit a traditional IRA, withdrawals are taxable at your personal income tax rate. Should a benefactor leave you assets like stocks, bonds and real estate, you won’t owe capital gains tax because of a legal provision known as the step-up in tax basis. Of course, should you sell those assets down the line after they’ve appreciated, you’ll face a capital gains tax.
How Business Sales Are Taxed
Proceeds of business sales are a little trickier. When a company is sold, the IRS typically treats each asset transfer as a separate transaction; some of these proceeds are considered ordinary income and others are considered capital gains. For example, proceeds from the sale of inventory are treated as ordinary income. Those from selling assets such as buildings, manufacturing equipment or vehicles are considered capital gains.
The Value of Trusts
Trusts can be exceedingly helpful for recipients of sudden wealth. For starters, trusts can provide a bulwark against the distant relatives and old friends popping up to request loans, gifts or investments in their start-up businesses. Once assets are placed in a trust, you can explain to petitioners that your co-trustee must sign off on any distributions. Whether that’s accurate or not is up to you. Better still, trusts can provide anonymity for recipients of large cash settlements, prizes or other windfalls. If you’re fortunate enough that you don’t really need your windfall, generation-skipping trusts allow you to pass it on to your grandchildren, which eliminates one generation’s worth of estate tax. These are just a few examples of how trusts can be useful for windfall recipients.
Updating Estate Planning Documents
Those who receive financial windfalls often reevaluate how they’d like to distribute their wealth. They may want to split up their estate differently among previously designated heirs, or they may add beneficiaries, including charities. Estate planning documents must be updated to ensure that such wishes are carried out after your death. Tax-management strategies play a central role in estate planning, of course. In cases where new wealth exceeds estate-tax thresholds, individuals and families may wish to leave more to charities, for instance.
How Your Financial Advisor Can Help
A financial windfall can change your life for the better. Making sure the benefit endures for you and future generations requires smart decisions when it comes to investing, tax management and estate planning. A skilled, experienced wealth advisor can help you align your goals with your assets and execute the steps that can turn sudden wealth into lasting fulfillment.
Footnotes
1“5 Lies You’ve Been Told About Generational Wealth”
2“What’s New – Estate and Gift Tax”
