Unexpected Inherritance

[bpc887]

Hello Friends,

A bit of background, I'm not married, 25 y/o, no children, currently maxing out both my 403(B) and Roth IRA each year for the last 2 years and expect to keep doing so going forward. 

Also, I have no debt or loans outstanding.

I recently received a $25,000 small inheritance.  Is there a way I can invest in another tax-advantaged method any suggestions are most welcome.

* I am not looking for stock tips.

[nereo]

I'm sorry for your loss - being left an inheritance is bittersweet.

The good news is that unless this is part of a much larger estate (>$5M) the inheritance should be tax free to you.
Where to invest it so that it grows tax free is harder, since you are already maxing out your IRA and 403(b).
You might want to fund a Health Savings Account - but only up to $3300.  You might still be able to contribute to 2013 until tomorrow - not sure about that.

Any debts you can throw the rest of the balance towards? Otherwise I'd pile it into a low-cost index fund.

[Frankies Girl]

Had the same thing happen to my husband back about 10 years ago. Family friend left him money. We called the IRS to make sure there were no taxes owed, and they confirmed. I'd probably want to double check again at this point tho.

Hmmm. Roth, HSA, then taxable would be my order. If you have to put into a taxable, just make sure whatever you invest in inside of that is tax efficient and you should be okay.

And very sorry for your loss.

[Poorman]

If you are contributing to a 403(b), you might want to check and see if your employer offers a 457(b).  My wife's school district started offering the 457(b) this year with absolutely no fanfare.  The only reason we found out is because I asked her to look into it with the district office.

[bpc887]

What is a 457(B), I'm not familiar with this sort of account?

[KatieSSS]

Hmmm. Roth, HSA, then taxable would be my order. If you have to put into a taxable, just make sure whatever you invest in inside of that is tax efficient and you should be okay.

If the inheritance isn't taxable, then why would you want to put it into a Roth, where you would be taxed this year? Wouldn't a traditional be a better way not to get taxed right now? I'm not just asking for this poster, as I will be in a similar situation in the summer. I'll be getting a small amount of inheritance, via a gift from my mother. She's giving me $13k, which is the highest gift you can give someone without it being taxed.

I don't want to hijack the thread with any more of my details, just curious what the logic is of doing a Roth first over a traditional IRA on money that you receive tax-free.

[nereo]

If the inheritance isn't taxable, then why would you want to put it into a Roth, where you would be taxed this year? Wouldn't a traditional be a better way not to get taxed right now? I'm not just asking for this poster, as I will be in a similar situation in the summer. I'll be getting a small amount of inheritance, via a gift from my mother. She's giving me $13k, which is the highest gift you can give someone without it being taxed.

Money from an inheritance isn't taxed at all, unless the estate is worth more than $5M under current laws.  When you file your taxes, it isn't listed as earned income at all.
So - regardless of whether you spend it on booze or put it into a ROTH, you won't pay income taxes on it.
Putting it into a ROTH ensures that you won't ever have to pay taxes on earned interest.

[KatieSSS]

Hmmm. Roth, HSA, then taxable would be my order. If you have to put into a taxable, just make sure whatever you invest in inside of that is tax efficient and you should be okay.

If the inheritance isn't taxable, then why would you want to put it into a Roth, where you would be taxed this year? Wouldn't a traditional be a better way not to get taxed right now? I'm not just asking for this poster, as I will be in a similar situation in the summer. I'll be getting a small amount of inheritance, via a gift from my mother. She's giving me $13k, which is the highest gift you can give someone without it being taxed.

I don't want to hijack the thread with any more of my details, just curious what the logic is of doing a Roth first over a traditional IRA on money that you receive tax-free.

FYI, it's now $14k/person/yr.

http://wills.about.com/od/understandingestatetaxes/a/historygifttax.htm

Also, that's per person to recipient transaction, IIRC. Thus, a mother could gift her daughter $14k, then gift her son in law $14k and then the father could do the same, for a total of $56k transferred without tax.

And I second this. A tIRA seems like a better option.

Sweet! I'll tell my mom :) Although I'm certainly fine with $13k. I didn't ask for any of it, but I think she feels like she didn't help me enough with my education, so this is her way of making it up to me a little.

So it seems like in the case of inheritance, there is a provision that if inheritance money is put into a Roth, then that isn't taxable. But in my case, when it is just a gift, this is taxable. Am I understanding that correctly?

[nereo]

FYI, it's now $14k/person/yr.

http://wills.about.com/od/understandingestatetaxes/a/historygifttax.htm

Also, that's per person to recipient transaction, IIRC. Thus, a mother could gift her daughter $14k, then gift her son in law $14k and then the father could do the same, for a total of $56k transferred without tax.

Perhaps I'm missing something - I was under the impression that an inheritance (money from an estate after a person dies) was taxed differently than the gift-tax (a transfer of money from one individual to another).  yes $14k is tax-free if it is a gift, but if it's in inheritance isn't the entire amount tax-free?
I think I lost the logic train somewhere.
If you receive money tax free, why would you put it somewhere where the interest will be taxed when you withdraw it (e.g. a t-IRA)?

[nereo]

I was letting KatieSSS know about the gift tax because it was relevant to her situation, not the OP's.

As for why contribute to a tIRA, it's because money is fungible. Let's say I make $70,000/yr. This year I also get a $15,000 inheritance, which is not taxable. I WILL still be taxed on that $70,000 I made, so it's advantageous to fund the tIRA. If the inheritance were my only source of income, that would be another manner, but the OP is employed.

Got it.  Thanks for the clarification.

[KatieSSS]

FYI, it's now $14k/person/yr.

http://wills.about.com/od/understandingestatetaxes/a/historygifttax.htm

Also, that's per person to recipient transaction, IIRC. Thus, a mother could gift her daughter $14k, then gift her son in law $14k and then the father could do the same, for a total of $56k transferred without tax.

Perhaps I'm missing something - I was under the impression that an inheritance (money from an estate after a person dies) was taxed differently than the gift-tax (a transfer of money from one individual to another).  yes $14k is tax-free if it is a gift, but if it's in inheritance isn't the entire amount tax-free?
I think I lost the logic train somewhere.
If you receive money tax free, why would you put it somewhere where the interest will be taxed when you withdraw it (e.g. a t-IRA)?

I guess the logic I was thinking about was this: receive $14,000 that isn't taxed in the beginning (i.e. it isn't salary so I'm not reporting it as such and thus it isn't taxed), so why put it in an account like a Roth where I will have to pay tax on it right away?

But the flip side, I guess, is that the money will grow and then I'd potentially pay MORE later if I put it into a tIRA and then pay taxes on the money when it comes out.

The debate for me is tIRA vs. Roth for this particular gift. I saw the OP had been given the recommendation to fund a Roth first, but I wasn't sure why that made sense since the money going into the Roth wasn't after tax, it was without any taxes taken out at all (inheritance). Unless I'm really missing something here?

[Eric]

I guess the logic I was thinking about was this: receive $14,000 that isn't taxed in the beginning (i.e. it isn't salary so I'm not reporting it as such and thus it isn't taxed), so why put it in an account like a Roth where I will have to pay tax on it right away?

But the flip side, I guess, is that the money will grow and then I'd potentially pay MORE later if I put it into a tIRA and then pay taxes on the money when it comes out.

The debate for me is tIRA vs. Roth for this particular gift. I saw the OP had been given the recommendation to fund a Roth first, but I wasn't sure why that made sense since the money going into the Roth wasn't after tax, it was without any taxes taken out at all (inheritance). Unless I'm really missing something here?

Your Roth money isn't taxed going in.  It's assumed that you've already paid applicable taxes on this money.  Therefore, putting it into a Roth costs you $0.00 in taxes and also saves you from paying any taxes on the earnings (assuming withdrawal after age 59.5)

The reason that it's an after tax account is that you don't get a tax deduction on contributions, not that you have to pay taxes on them.

[KatieSSS]

I think what you're missing here is that money is fungible. Ignore the inheritance issue for a second and imagine this.

You're a broke college student, and your mother gives you $100 bill for Christmas and tells you to spend it on groceries. Conveniently, your grocery budget is $100/month, so you take your shiny $100 bill to the grocery store, and buy food for the month. But this means you didn't spend the $100 from your waitressing job on groceries, so you use that $100 for a new winter coat. Did your mother buy you the coat, or the groceries? It doesn't really matter which $100 you spent on groceries and which you spent on the coat, right? Money is money is money. Your mother gave you an extra $100, which padded out your monthly budget and let you buy some other stuff. That's fungibility.

So let's consider the OP's situation. He's going to make, say, $75,000 on his W-2, and receive a tax-free inheritance of $25,000. What you are doing is pretending these $25,000 and $75,000 are different pots of money, but they aren't. They're one $100,000 pot of money, of which the first $25,000 is tax-free. He's still going to be paying a whack of income taxes on that W-2 income, so that needs to be considered when deciding what form of tax-advantaged savings account. The inheritance pot isn't some separate money-pile, it needs to be considered in the context of all his other income.

I get that money is money is money. I think where I'm lost is that the W-2 income is automatically reported. But is the $25,000? If not, then why put it in an account that is going to say "tax me now!" like a Roth would? To use your analogy, if my mom gives me $100 in cash for a coat, but I decide I want to invest that instead, why would I put it in a Roth when she gave it to me without me having to pay tax on it? If I earned $100 from my job and wanted to invest it, it would be taxed as income first. The $100 cash from my mother wouldn't.

ETA: Whoa whoa...I think I have fundamentally misunderstood Roth's my whole life! My Roth contributions have always been reported on my tax returns, so I was assuming I was paying tax on the amount I contribute. As in, I contribute $5,000 and I'm taxed on that actual $5,000. That's not the case?! Holy cow...I need to go read up on this. Because I think now I get what I'm missing here.

[seattlecyclone]

ETA: Whoa whoa...I think I have fundamentally misunderstood Roth's my whole life! My Roth contributions have always been reported on my tax returns, so I was assuming I was paying tax on the amount I contribute. As in, I contribute $5,000 and I'm taxed on that actual $5,000. That's not the case?! Holy cow...I need to go read up on this. Because I think now I get what I'm missing here.

Right, there's no special "putting money in a Roth IRA" tax. A Roth IRA is just an account where you're allowed to put some of your money each year after you pay the regular amount of tax on this money. In the case of an inheritance, the regular amount of tax is $0, so you can use some of this money to max out your Roth IRA and never pay tax on that money again.

[KatieSSS]

Ok I totally get it now! Wow, I feel like a lightbulb went off in my head. I think the phrase "pay tax on it now" in relation to the Roth had me thinking you were taxed extra when you filed at the end of the year.

Sorry OP, for hijacking this thread. But this has been very informative and will really help me out when I need to make the most of this gift money. I'll definitely put the max towards my Roth now that I get what is going on with the tax aspect.

[Vjklander]

Ok I totally get it now! Wow, I feel like a lightbulb went off in my head. I think the phrase "pay tax on it now" in relation to the Roth had me thinking you were taxed extra when you filed at the end of the year.

Sorry OP, for hijacking this thread. But this has been very informative and will really help me out when I need to make the most of this gift money. I'll definitely put the max towards my Roth now that I get what is going on with the tax aspect.

"pay tax on it now" would apply if you were using current earned income to fund the Roth IRA.  As far as this thread goes, whether gift or inheritance the money appears in your checking account tax-free like by magic. Whether to fund a Roth or TIRA should be analyzed based on the totality of your situation; current marginal tax rates vs expected retirement income etc.  If there is still cash left over and your credit is paid off, by all means put the money in a taxable account and let it work for you establishing a lifetime cash flow.