Welcome to NerdWallet’s SmartMoney podcast, where we answer your real-world money questions.
This week’s episode starts with a discussion about the recently proclaimed recession and how that can change the way you handle your finances.
In the Great Recession of 2007 to 2009, the median amount of time people were out of work rose from about two months to more than six months. That’s a long time to be without a paycheck. Save more now if you can, but also try to protect and expand your access to credit. Having unused space on credit cards or home equity lines of credit can be a lifeline if your emergency fund isn’t enough.
Then we pivot to this week’s question from Alice in Ohio. She says, “I have a question about inheritance. I inherited an amount of money, $10,000, through a bank account that I was beneficiary of. Do I have to pay income tax on that amount?”
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The short answer is no. People don’t have to pay income taxes on inheritances or gifts they receive.
Income taxes aren’t the only kind of taxes, of course. A few states charge inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. These taxes are based on who receives the inheritance — spouses and children are usually exempt, and the rate goes up the more distantly related you were to the deceased. Also, very large estates — those worth more than $11.58 million — may owe estate taxes to the IRS and sometimes the state. Those taxes are paid by the estate rather than the person receiving the inheritance. Gift taxes are related to estate taxes: When they’re owed, which is rarely, they’re paid by the giver rather than the receiver. You would have to give away more than $11.58 million during your lifetime to owe any gift taxes.
The next question with any windfall is: What should I do with this money? Paying off high interest-rate debt and boosting your emergency fund are usually good choices. If you have a goal that’s more than 10 years in the future, investing the money in the stock market can be a smart move. But it’s also OK to take a certain amount, say 10%, and just blow it on something fun. You’ve got to live a little, right?
You typically don’t owe any tax on money that you inherit or are given. Only a handful of states tax inheritors. For most people, inheritances and gifts are tax free.
Estate and gift taxes really aren’t a thing for the vast majority. You’d have to die with more than $11 million for your estate to owe estate taxes. People who give away money sometimes have to file gift tax returns, but they won’t owe gift taxes until they’ve given away more than $11 million in their lifetime.
Don’t blow your windfall. Have some fun, but use most of the money to save, pay down debt or invest.
More about windfalls on NerdWallet:
Sean Pyles: And I’m your other host, Sean Pyles. As always, be sure to send us your money questions. You can call or text the Nerd hotline at (901) 730-6373. That’s (901) 730-NERD. Or you can email us at [email protected]
Liz: And while you’re at it, please rate, review and subscribe wherever you’re getting this podcast.
Sean: This episode, we’re tackling a listener’s money question about how to handle an inheritance. But first in our This Week and Your Money segment, Liz and I are going to talk about how to manage your money in a recession.
Liz: The National Bureau of Economic Research, the organization that decides these things, announced that the U.S. economy peaked in February and we’re now officially in a recession.
Sean: And that can change how you manage your finances. It’s challenging because a lot of people feel like they maybe didn’t recover from the last recession and now there’s another one. I know a lot of millennials are in that camp, but there are some things that you can do to improve your financial resilience right now. And so, Liz, I’m interested in talking with you about how people can do that, what your advice has been for folks in previous recessions and ways that we can all get through this, because we don’t really know how long it’s going to last.
Liz: I want to say right off the top, I sometimes see articles, and I think I’ve even written articles that say how to recession-proof your finances. You cannot recession-proof your finances. Every recession is different. Things happen that we don’t expect. With the last recession, the Great Recession, the duration of unemployment got crazy. The median duration of unemployment stretched from the usual two months to six months, and six months is really long time to be out of work. Very few people are prepared for anything like that. So we don’t know what’s coming and we don’t know how it’s going to shake out. But all that being said, there are things you can do to put yourself in a better position. And probably one of the big things is save like a maniac. You want to be pumping up that emergency fund right about now.
Sean: It does seem like unemployment could be a pretty significant parallel with the last recession. And if people are unemployed for three months, six months, I’m wondering how you think people can withstand that length of time of unemployment?
Liz: The important thing is to focus on your financial flexibility. So having some savings is super important, but you also need access to credit because that’s a backup. If you run through your savings, which people will do, at least you can tap credit cards, a home equity line of credit, something like that. To do that, you need to protect your credit scores. And that gets tricky in a recession. When your income drops, it can be really tempting to let bills slide. You really have to stay on top as much as you can with at least paying the minimums of your loans and your credit cards. If you can’t do that, you want to go for an official forbearance. Don’t just skip payments, contact your lenders. Most of them have a hardship program right now. See if you can get on that. That can buy you some wiggle room. It’ll keep your accounts in good standing so that your credit scores will be preserved, and that gives you access to credit so you can wait this thing out.
Sean: And also with the unemployment risk, there’s no way to totally mitigate the risk of losing your job. I’ve seen articles that talk about ways that you can diversify your income right now. And to be honest, I kind of hate that side hustle advice of picking up a delivery job or whatever it may be in this quarantine economy that we’re in right now, because I think that it puts a lot of pressure and guilt on people to be constantly producing something and earning money, when in fact if you spend three hours doing a job like that, you actually might be taking away the opportunity to find a more long-term job. I don’t know. I just struggle with that advice because it seems like an easy suggestion that might actually be divorced from the reality of people’s job prospects.
Liz: It’s a really hard line to navigate because you don’t want to just sit there and let things get worse. On the other hand, there might not be jobs available or there might be a ton of competition coming up because those rather generous unemployment benefits we have right now because of the CARES Act, those are set to expire at the end of July. There are going to be a lot of people rushing to find jobs at that point, so lots of competition. So my instinct is if a side hustle will help you out right now, it’s maybe not the worst thing in the world, but over time you want to have a decent income, which you’re not going to get from most side hustles.
Sean: Since we’re in this early point in the recession, we’re still in that preparatory phase, and I think there are some things that people can do. An easy one that we talk about a lot is really trimming the unnecessary expenses from your budget and finding ways to minimize expenses that you do have.
Liz: One of the reasons we really like the 50-30-20 budget is it makes sure that you’re limiting your must-have expenses, and it’s good to trim the smaller expenses, but really you get a lot further if you can trim the big ones, which are shelter, particularly, and transportation. Those two make a huge difference in whether people feel like they’re comfortable or whether they’re struggling to get by. With the shelter, we were talking recently about how rents are going down in some cities. So maybe you want to negotiate with your landlord. If you’re still able to pay your rent, maybe you could get a better deal or look for a better apartment or a different apartment when it’s less expensive. If you have a mortgage and you still have a job, great time to refinance. Get those payments down. And don’t be in such a hurry to pay off your mortgage or student loans because you cannot get that money back. Generally, if you’re trying to be careful, if you’re trying to be prudent, when you’re in a recession or with a recession coming on, you want to preserve as much cash as possible. Get your expenses down where you can, save as much as you can, and definitely don’t sign up for a big new expense right now. That would not prudent.
Sean: And on the housing front, I have a number of friends that live in cities that have rent control. San Francisco comes to mind as one of them. And a few of them weren’t really planning on moving, and now that they’re seeing rents going down, they’re trying to lock in an apartment that has a lower monthly expense. It’s similar to refinancing in a way, because you’re just making your housing costs for the foreseeable future be less expensive. And because these cities have rent control, they know that their landlord can only increase it a certain amount every year, which is a really smart move right now. So even though they weren’t planning on moving and moving is totally a pain, it could save you money in the long run and provide a little bit more stability in that regard.
Liz: There’s a lot of decisions that you can make where you’re locking in a better deal going forward. Transportation is one of them. The type of car you buy, how much money you spend on that car has a huge impact over your life. Because if you’re buying an expensive car with expensive repairs, you’re going to pay a lot more than a less expensive, more reliable vehicle that you can just drive forever. So thinking about those big expenses is really important.
Sean: Another thing I wanted to touch on is investments. A lot of people get scared with how their 401(k) or their other investments could depreciate value as the stock market goes up and down. It seems like every other week it’s just crashing and then it’s higher than it ever was before. There’s so much uncertainty, but don’t mind the swings from one week to the next. You’ll just make yourself anxious.
Liz: Yeah. And actually over time, the thing that matters the most is how much you’re investing, how much you’re putting aside. What happens to the balance as it goes up, it goes down, it’s basically noise. So what matters is how much you’re putting in. So if you really feel like you have to do something, go to HR, if you still have a job, and bump up your contribution rate.
Sean: Right. I think the lesson here is to do what you can to brace for any uncertainty that might come your way and hunker down for the long haul. And I think that’s about it for now. I’m sure we’ll revisit the subject because, as we mentioned, we don’t know how long this recession is going to last. And listeners, if you have any questions around how to manage your money in a recession, please send them our way. Now let’s get to this episode’s money question.
Liz: This week’s question is from Alice in Ohio. She says, “I have a question about inheritance. I inherited an amount of money, $10,000, through a bank account that I was beneficiary of. Do I have to pay income tax on that amount?"
Sean: That’s a really interesting question, Alice. And to me, it also raises other questions about how inheritance is taxed generally. But I’m also wondering about what might be the best way to use an inheritance like this. And these are all questions that you can help us answer. Right, Liz?
Liz: Yes, absolutely. There’s a lot of misconceptions about how inheritances and gifts are taxed. So we can help clear that up and help you figure out what you need to do with your money when you do get a windfall.
Sean: All right. Let’s get to it. Okay, Liz, let’s get straight to the meat of Alice’s question. Does she owe income tax on this $10,000?
Liz: Nope, and that’s the good news.
Sean: That’s great.
Liz: Yeah, absolutely. People hear about inheritance taxes, estate taxes, death taxes, and they just assume that if they get money, that they’re going to have to pay the tax. And that’s not how it works at all. There are a couple of states, a few states, I’m thinking six, that still have inheritance taxes. You might face that for larger amounts, but generally the closer you are to the person, the less you have to worry about having to pay an inheritance tax.
Sean: OK. So Alice lives in Ohio. Is that one of the six states?
Liz: Ohio is not one of the six states, so it doesn’t have an inheritance tax. That’s the good news.
Sean: All right. So she doesn’t owe taxes on this, but you mentioned a few different kinds of taxes, estate tax, inheritance tax, death tax. Can you break down what each of these is and what they might mean for someone getting money from a recently deceased loved one?
Liz: Yes. So the most important thing to know when you’re talking about estate taxes and gift taxes, is that the vast majority of people do not have to worry about this. So if you’re looking at estate taxes, it’s only estates worth more than $11 million. It’s actually a little bit higher than that, but only estates . . .
Sean: That’s a lot of money.
Liz: That’s a lot of money, and most people are not going to be in that bracket. So those are the estates that may owe estate tax. For most other people, it’s not going to be a big deal. And when I’m talking about estate tax, that is paid by the estate. It’s not paid by the people who receive the money. So the dead person — essentially their estate — is going to pay any tax that’s owed. You don’t have to worry about it if you’re getting the inheritance. So death tax is generally referred to as either estate or inheritance taxes. We talked about the fact that most states don’t have inheritance taxes, but an inheritance tax is something that is paid by the beneficiary. If you are unfortunate enough to be in one of the six states that charge it, you have to be aware of it, but most people do not.
The final tax that people need to know about is called a gift tax. People hear that and think, “Oh, I’m going to have to pay tax on any gift I get." No. Once again, it’s not the recipient that has to pay a gift tax, it’s the giver. Also, once again, you have to give away a whole lot of money before you even have to worry about this. So there’s something called the annual exclusion. That means that you can give, Sean, you can give every one of your friends and family $15,000 a year and you don’t have to file a gift tax return.
Sean: I wish I could do that.
Liz: Yeah, I know. Wouldn’t that be great, passing the money around?
Liz: So even if you were able to do that, it was only if you were giving away more than that amount per person, that you would even have to file a gift tax return. So most of the time, IRS doesn’t want to know about your gifts, but if you’re giving away a ton of money, then you do have to file a gift tax return. But once again, you don’t even owe the gift tax until you, Sean, have given away $11.58 million above that $15,000 per person annual amount. Does that make sense?
Sean: Got it. Yes. Lots of numbers. What I’m getting from here is again, more money, more problems. I’m glad I don’t have 11 point something million dollars to have to worry about right now because of this.
Liz:: Well, and honestly if you did, you could afford to hire a CPA and an estate planning attorney to help you with all this.
Sean: Yes, yes, yes. OK, great. So she doesn’t owe taxes on this money right now. Is there any chance that that could change in the future? I’ve heard capital gains tax can somehow get mixed in with money like this. Is that a concern that she should be thinking about?
Liz: Well, yes and no. So where capital gains taxes are particularly worrisome is if we’re talking about a gift. And we’re not here, remember she inherited this money. So we’re going to put Alice aside for a moment. But let’s say your parent has a house and your parent wants to give this house to you. So if you inherited it, then you wouldn’t have to worry about capital gains taxes right away, because all of the appreciation that happened during your parents’ lifetime essentially goes untaxed. So let’s say your parent bought the house for $20,000. It’s worth $2 million now. And if you inherit the house, all of that gain, the $2 million minus the 20,000, all of that gain never gets taxed. So you inherit the house, you get what’s called a step-up in basis. So the house is essentially valued for tax purposes at $2 million. And it’s only if you sell it down the road that you have to worry about capital gains taxes.
Sean: OK. That sounds like a pretty good deal.
Liz: It’s a great deal. And it’s the deal that’s available to most families. So it’s kind of the hidden benefit of the estate tax system that most people don’t think about, which is that a lot of assets are being passed to heirs. No one ever owes tax on that. The appreciation just sort of disappears and they get the benefit from it without having to pay the tax. OK, that’s the situation if you inherit. If instead, your parent decides to give you the house while the parent is still alive, that is a tax bomb just waiting to happen. So what happens here is instead of getting that nice step-up in basis to where you get the house at $2 million or whatever, now you’re getting the house, but you are also getting your parents’ tax basis. In other words, the $20,000. So if you turn around and sell that house, then you’re owing tax on all that appreciation that happened during your parents’ lifetime. The short version of this is don’t let your parent give you a house.
Sean: At least not until after they die.
Liz: Exactly, exactly. And if they are insisting on this, get yourself to an estate planning attorney. Get yourself to a tax pro at the very least, so they can explain this to your parent and why it’s a bad idea, because a lot of parents want to do this. They think they can protect the house from nursing home bills. They think it’s a good thing to have their kid on the deed. They have no idea.
Sean: Yeah, it seems well intentioned, but the timing isn’t correct.
Liz: Exactly, yeah. They mean to do the right thing and they’re just doing the absolute wrong thing as far as your tax bill. So to bring it back to Alice, she doesn’t have to worry about it because she’s inheriting cash. So there’s no tax issue there with capital gains. If she should invest the money and that should go up in value, which occasionally stocks will do, then she’d have to pay capital gains on whatever the appreciation happened during her lifetime.
Sean: Got it. Because basically at that point, it’s her own money. And so she will be using that money and it would be taxed according to any investment taxes that would be out there.
Liz: Yeah, exactly.
Sean: So that really leads me to another thing I was wondering about is $10,000 is a pretty good chunk of change. I’m wondering if you have any thoughts about what she might do with it.
Liz: OK. Well, what a financial planner would say is they’d sit down and go, “OK, do you have an adequate emergency fund?" Typically that’s three months’ worth of expenses, maybe six months. If that’s covered, then the next question is, do you have any toxic debt? And toxic debt is, it’s high rate, variable rate debt, which could be credit cards, payday loans, anything like that. If you have toxic debt, then you definitely should pay that off. If you’re covered on those two aspects, then the next question is how are you doing with your retirement savings? Could you put more into your IRA or your 401(k)? And the way to get the money into the 401(k) is you can’t put it in directly, but what you do is you bump up your contribution at work and then you pull the money out of that $10,000 to cover what’s missing from your paycheck.
Liz: So, that’s the way a financial planner would look at it. They’d want to make sure you have the emergency fund, then look at your toxic debt and then look at your retirement. If you’re covered on all those things, and you just want to have fun, you could do that, or you could invest the money if you have a long enough time horizon. But any investment, I would say you’d want to be able to leave it alone for 10 years before you put it in the stock market.
Sean: Yeah. And we don’t know Alice’s age here. I’m wondering how you think that would impact how she “should" use this money.
Liz: Yeah. Again, if you are 20 and you have decades until retirement, and you don’t need the money right away, then you could put most of it, if not all of it, into stocks. If you even wanted to speculate a little bit, gamble a little bit, play the market or try to pick some stocks, that amount of money could be a lot of fun to play with. But if you’re on the other end of the spectrum, if you’re in your 80s or whatever, probably conserving your capital, conserving your money, not taking too much risk is going to be the most important thing. So maybe you just want to tuck it away in an FDIC-insured high-yield savings account.
Sean: Yeah. So maybe in that case, a certificate of deposit account for a year or five years might be a decent idea because you can still invest it to some degree, but it’s a little bit less risky. Right?
Liz: Yeah, exactly. And we don’t know what’s going to happen with interest rates going forward. So, not a bad idea to grab a CD now, if you can.
Sean: OK. Awesome. Well, do you have any other final words of advice for this chunk of change or for how Alice should think about this inheritance?
Liz: One thing to keep in mind is that even if you’re going to be responsible with a windfall, and I think you should be, it’s also OK to take, say 10% of the money and just have some fun. So if you’re going to put $9,000 towards your credit card debt or whatever, go ahead and blow a thousand bucks. I mean, it’ll make you feel good. It’s money out of the blue. So that can help you stay the course while still doing the right thing with most of the money.
Sean: Yeah. I think having fun is always good advice, while being responsible about it.
Liz: Yeah. And people who are beneficiaries and inherit money are well aware that life doesn’t last forever. So you have to have a balance between taking care of the past, providing for the future and enjoying your life today.
Sean: Sage advice, Liz.
Liz: All right. So it’s time to get to our takeaway tips. Takeaway tip number one, you typically don’t owe any tax on money that you inherit or are given.
Sean: Next up, estate taxes are rarely owed and they’re paid by the estate, not by the inheritors.
Liz: And finally, don’t blow your windfall. You can have fun with some of the money, but make sure you use the bulk of it to shore up your emergency fund or pay down debt.
Sean: All right. And that is all we have for this episode. Do you have a money question of your own? Turn to the Nerds and call or text us at (901) 730-6373. That’s (901) 730-NERD. You can also email us at [email protected] Also visit nerdwallet.com/podcasts for more info on this episode. And remember to subscribe, rate and review us wherever you’re getting this podcast.
Liz: And here’s our brief disclaimer, thoughtfully crafted by NerdWallet’s legal team. Your questions are answered by knowledgeable and talented finance writers, but we are not financial or investment advisors. This Nerdy info is provided for general educational and entertainment purposes and may not apply to your specific circumstances.
Sean: And with that said, until next time, turn to the Nerds.