If you've struggled to get ahead financially for most of your life, you might see an inheritance from your parents as your best chance for becoming financially comfortable or even wealthy. However, counting on an inheritance to solve your financial problems is a bad idea. Receiving an inheritance requires the death of people you love, and you might not get the windfall you were expecting. Here's why.
Your Parents Might Spend the Money Themselves
Your parents worked hard for decades to earn their nest eggs, and they may not be planning on leaving much behind. If they're fortunate enough to have more than they need to retire comfortably, they might spend the extra money on luxuries they couldn't afford when they were younger. Also, healthcare costs eat up a significant portion of most people's retirement savings, and with all the uncertainty surrounding Obamacare, it's impossible to predict what healthcare costs will look like in the future. If your parents live longer than anticipated, their retirement savings may simply run out. In fact, you might end up supporting your parents in their old age - quite the opposite of an inheritance.
The specific nature of your parents' nest egg could also limit what you receive when they die.
"Retirees that are currently in retirement tend to have defined benefit pension plans, and once they die, so does the payment stream," says Michael J. Fitzgerald, president of Fitzgerald Financial Partners, a Houston-based, fee-only financial advisory firm.
You Don't Know What You're Getting
Some parents tell their children exactly what they plan to leave them when they die. Others prefer to keep their financial affairs private. If your parents fall into the latter category, there's no point in counting on an inheritance because you don't know if your parents are planning to leave you $500,000 or $1. They might be planning to leave their assets to a favorite charity; they might not have any assets. If you have siblings, any money that your parents do leave will probably be divided among you.
A Typical Inheritance Won't Change Your Life
Many people don't receive any inheritance, and of those who do, the median inheritance for today's baby boomers is only $64,000, according to a 2010 study from the Center for Retirement Research at Boston College. That's nothing to sniff at, but it's probably not enough to dramatically change most people's lives.
In fact, you might burn through any money you do receive. San Francisco-based estate planning attorney John O'Grady, says that most people quickly spend an inheritance of any amount unless they purposefully create a long-term plan for the windfall. Without a plan, they may compulsively spend the money on big-ticket items, debt payments and donations, especially because they are not thinking clearly in the aftermath of a loved one's death. (For more, check out Leaving Inheritance To Children Easier Said Than Done.)
Probate and Taxes Often Take a Bite
If your parents don't do any estate planning before they pass away, the assets they leave you could take a significant hit from probate and taxes. Probate is the process by which a court reviews the deceased's will for validity and authenticity, and appoints the executor named in the will to distribute the deceased's assets. If there is no will, the person is said to have died "intestate." Probate will then appoint an administrator to distribute the assets according to state intestacy laws. Regardless of what your parents may have wanted, if they didn't correctly formalize it in writing, the state will make the important decisions about their assets.
The court and attorney fees associated with probate typically reduce the value of the deceased's estate by 3 to 7%. The estate administrator or executor may also charge a percentage fee; settling an estate can be a complex and time-consuming job. If anyone contests the will, these fees will increase. Also, probate can take as long as one to two years, which means that even if you are due an inheritance, you may be waiting longer than you thought to receive it.
Probate and its associated fees and waiting period can all be avoided by creating and placing property into a trust, but many people never establish trusts because they don't understand them or think they are only for rich people. But trusts aren't just for the wealthy, and a qualified estate-planning attorney can explain how trusts work and help parents select and establish the right trust.
Whether your inheritance will be subject to estate taxes depends on its size, and the ever-changing state and federal estate tax exemptions. In 2012, the federal estate tax exemption is $5,120,000.
The Money Could Come with Restrictions
If trusts have a drawback, it's that by placing their assets into certain types of trusts, your parents can continue to control their money even after they're gone. For example, parents can use an incentive trust to reward beneficiaries with trust money for particular behaviors, such as attaining a college degree, holding a job or working in the family business. They can also use trusts to punish undesirable behaviors, such as smoking and illegal drug use by withholding money from would-be beneficiaries. Trusts can also be set up so that beneficiaries don't receive the money all at once, but receive it gradually as they reach certain age milestones.
The Bottom Line
"Relying on an inheritance can diminish an individual's work ethic and feeling of self-worth," says Andrew M. Aran, CFA and partner with Regency Wealth Management in Midland Park, New Jersey.
Furthermore, there are numerous uncertainties surrounding whether you will receive an inheritance, and how large it will be. For all of these reasons, the best way to provide for your financial future is to take steps that you have complete control over, such as maximizing your income, minimizing your expenses, budgeting wisely and funding your own retirement account. (For related reading, see Encouraging Good Habits With An Incentive Trust.)