Life Change: Inheritance or Settlement Events

Whether you are the beneficiary of a large estate, a life insurance policy, or have won a recent settlement in court, receiving large sums of money can be quite overwhelming. Inherited assets and court-ordered monetary awards often come with varying tax treatments and distribution methods. This is why we recommend inheritance planning, so you understand how to make your financial blessings last.

Your First Steps in Inheritance Planning

The best first step after receiving a large sum is usually to wait. Put the money somewhere safe and liquid while you gather documents and understand what you have received. Decisions made in the first few months, such as paying off debt, buying a home or giving money to family, are hard to undo.

Each type of asset is taxed differently, which is why a plan matters. Inherited retirement accounts have their own withdrawal rules. Most non-spouse beneficiaries must empty an inherited IRA within ten years, and a surviving spouse has additional options. Inherited stocks, funds and real estate generally receive a new cost basis at the date of death, which can reduce capital gains tax when they are sold. Life insurance proceeds paid to a beneficiary are generally not taxable income.

How Settlements Are Taxed

Compensation for a personal physical injury or physical sickness is generally not taxable. Punitive damages are taxable, and so is compensation for emotional distress that does not come from a physical injury. Interest on an award is taxable, and workers’ compensation benefits are generally not. Because the details matter, we review your settlement documents with your attorney and tax preparer before you invest the money.

Once the tax picture is clear, we help you decide how much to keep in cash, what to put toward debt and how to invest the rest for your goals. Read more in our article on handling inheritance and settlement events.

Do I have to pay tax on an inheritance?

There is no federal inheritance tax on the person who receives an inheritance, and Connecticut does not have an inheritance tax. Connecticut does have an estate tax, which is paid by the estate before assets are distributed. Some inherited assets, such as traditional IRAs, create taxable income when you withdraw from them.

How long do I have to withdraw an inherited IRA?

Most non-spouse beneficiaries must withdraw the full balance within ten years of the original owner’s death, and some must also take annual withdrawals during that time. Spouses and certain other beneficiaries have more options. The timing affects your taxes, so it is worth planning before you take money out.

Is my legal settlement taxable?

It depends on what the payment is for. Compensation for a physical injury is generally not taxable, while punitive damages, interest and most emotional distress awards are. Review the settlement terms with your attorney and tax preparer before you sign if you can.

Should I pay off debt or invest an inheritance?

It depends on your interest rates, your emergency savings, your goals and the tax treatment of what you received. We look at all of these together in your inheritance planning so the money has the most lasting effect.

If your family is preparing to pass wealth to the next generation, read The Great Wealth Shift from Baby Boomers to Millennials.