The 10 Best Assets to Leave to Your Heirs
Not all inherited assets share equal tax treatment. As you consider your own estate plans, it’s important to know how your assets will impact your heirs when they make distributions.
We recently released a post titled “How to Leave an Inheritance” and although we included parts of this topic in that post, I felt like a more thorough look was warranted.
This article will cover common assets that are passed along through an inheritance, the tax implications of each one, and why said assets may or may not be desirable to your heirs.
Finally, we’ve ranked them in order from 1 to 10 based on how your heirs would generally prefer to receive these.
We wrote it this way because people generally prioritize their spending in such a way as to benefit their heirs. If that’s not a concern of yours, then you shouldn’t necessarily follow this ranking yourself.
1) Roth IRAs and Roth 401(k)s
Taxes: Roth assets are inherited completely tax-free.
Probate Treatment: IRA accounts are directed to the beneficiaries as directed by the owner to the account custodian. They do not pass through probate.
To begin, inherited 401(k)s have similar requirements to inherited IRAs. In all likelihood, you’ll prefer to roll the 401(k) to an IRA anyway.
From a Roth IRA, heirs have up to 10 years after your death to distribute the assets from the account.
This means if your heirs drag their feet they can benefit from tax-free earnings in addition to the amount inherited for up to 10 years after you pass.
That tax-free growth is something you can’t get from cash alone. That’s why we ranked Roth accounts as our number one inherited asset.
However, the Roth account has to be at least 5 years old for the earnings to be completely tax-free. So, open one today and toss a dollar in to satisfy the five-year rule.
2) Cash
Taxes: Inherited cash assets are not taxable unless the estate’s value exceeds estate tax exemptions.
Probate Treatment: If you have a joint account or have named beneficiaries, the assets do not have to go through probate. Otherwise, they might.
This seems self-explanatory. The Roth was only better than cash because it provides an opportunity for continued tax-free growth.
But I have a feeling your heirs would be happy with cash too.
Cash could be like actual greenbacks or in a bank savings, checking, money market, or CD.
The cash in the bank will be more challenging to get out than cash in hand, but it will also be safe from loss, theft, or destruction at the bank.
If you have the option, you should declare your beneficiaries to the bank to make transfer easier after your death.
Do not add your heirs to your banking accounts to help them avoid getting the cash through probate. Keep reading below to see why.
3) Life Insurance
Taxes: Almost always, life insurance benefits are not taxable.
Probate Treatment: Insurance benefits do not pass through probate because they’re not inheritance.
Ranking life insurance is a little complicated.
There is no tax on life insurance benefits and the benefit is given in addition to the assets of the estate.
So, in a way, life insurance is worth more to your beneficiaries than the same amount in the value of your assets.
However, not all life insurance policies are created equally.
Given the cost of permanent life insurance, your heirs might prefer that you had saved your premiums and invested them instead.
So, term life insurance is a great financial benefit to your beneficiaries.
A permanent insurance benefit is normally worth less than the cumulative value of the premiums paid into the plan, so your heirs would probably be better off inheriting equities with a free step-up in cost basis.
If you are among the small group of people for whom permanent insurance makes good financial sense, you can disregard my cynical view of permanent life insurance policies.
4) Equities: Treasuries, Stocks, Bonds, Mutual Funds, etc.
Taxes: Free step up in basis, so no immediate taxes. Any gains after receipt by heirs are taxable.
Probate Treatment: Does not pass through probate if beneficiaries are named.
Most assets that are not in the envelope of some sort of unique tax designation receive a free step up in tax basis when they are transferred after death.
This means any capital gain in the value of the asset is waved by the government and not owed by the heir.
For example, suppose your Uncle Buck left you 500 shares of Coca-Cola stock when he died.
Let’s say the shares were worth $300 each when you inherited them and were worth $100 each when Uncle Buck bought them. That’s a capital gain of $200 per share.
Normally, when the assets are liquidated the owner would owe capital gains tax on $100,000 (500 shares x $200 per share).
When you inherit the shares of stock, however, the IRS treats the stock as if its basis (or purchase value) is the price of the stock on the day you inherited it.
So, if you sell the stock before it appreciates further, you will realize no capital gain and pay no taxes on the distribution.
This is especially important to remember if you have significant assets in a taxable brokerage account because the distribution of those assets creates a tax liability for you as the owner in the form of capital gains taxes.
However, if you pass away having never realized a distribution from your appreciated assets, your heirs get them completely tax-free.
The rub here is if you decide to use traditional pretax IRA or 401(k) assets for income instead, you’ll owe income taxes on the distributions which are higher than even long-term capital gains or dividend taxes.
You’ll have to decide if you want the tax break or if you want your heirs to get it, but, mathematically, there is more available benefit on the table for the heir than the owner.
5) Personal Real Estate
Taxes: Free step up in basis.
Probate Treatment: Passes through probate.
Like equity assets, real estate receives a free step up in basis at the time of the deceased’s death.
So, if your parents bought their home fifty years prior and it has increased in value, you won’t have to worry about capital gains if you inherit the house.
You will, however, have to appraise it or figure out another way to calculate its value when your parents died, which is much more difficult than locating a stock price.
Bear in mind that each taxpayer receives a $250,000 exemption from capital gains taxes on the sale of a primary residence. That’s $500,000 per couple.
This could be important to remember if your parents need to move into another facility as they age.
If the home has appreciated beyond this exemption amount, they may want to keep the home to avoid capital gains taxes and to pass it along to their heirs tax-free.
The home must serve as the owner’s primary residence for at least 2 of the previous 5 years to maintain the exemption.
Real estate isn’t better or worse than other assets from a pure tax point of view at the time of inheritance. However, it’s much more difficult and costly to liquidate than equities.
We’re ranking it after equities because of the hassle factor.
6) Rental Property
Taxes: Free step up in basis, but you will owe annual property taxes if you decide to keep it.
Probate Treatment: Passes through the probate process.
Rental property also receives a free step up in basis, so it’s a lot like inherited personal real estate.
With one notable exception…
You have a tenant.
If you’ve always wanted to be a landlord, this is a convenient way to start that journey.
But if you have no aspirations to be a landlord, you get the headache of liquidating the asset plus having to navigate any contractual obligations you have to your tenant.
If the tenant has been there a while, paying their bills on time, and not trashing the place, you might consider just enjoying the secondary income stream to see how it suits you.
Otherwise, you’ll probably want to reach out to an agent to connect you with a buyer interested in a rental property or see if the tenant is interested in buying the property outright.
7) A Business
Taxes: Free step up in basis.
Probate Treatment: Passes through the probate process.
Inheriting a business could mean a lot of things. Regardless, it will likely be pretty complex.
Inherited businesses, like most assets, receive a step up in basis and have to pass through probate.
Unlike most assets, businesses can be challenging to value and their structure could make liquidating your share of the company a long, arduous, and expensive process.
You’ll need legal and accounting help to establish the value of the company and your portion.
You’ll have to consider how staying in the company or stepping out will impact the employees and other stakeholders in the organization.
Again, due to the hassle factor, this isn’t an ideal way to receive an inheritance, but it beats receiving nothing at all.
8) Traditional IRAs & 401(k)s
Taxes: Taxed at the heir’s marginal income tax rate.
Probate Treatment: Does not pass through probate if beneficiaries are named.
As we pointed out earlier, you can’t inherit a 401(k). They get converted and rolled into an inherited IRA.
Inherited IRA distributions are fully taxable at the beneficiary’s marginal income tax rate and beneficiaries must liquidate the account within 10 years after the deceased passes away.
So, unfortunately, IRAs don’t really provide any tax advantages for the beneficiaries at all, but they are easier to obtain than assets that pass through probate.
They also provide a decade-long shelter for pretax assets to grow, which is of some benefit.
There is some debate as to whether one has to withdraw an RMD from an inherited IRA each year. My understanding is it depends on whether or not the original owner had begun taking RMDs themselves.
To add to the confusion, the IRS has provided less than clear and even confusing direction on this. Click the inherited IRA link above for more information.
9) HSAs
Taxes: Fully taxable at the beneficiary’s marginal income tax rate in the year it is received.
Probate Treatment: Does not pass through probate if beneficiaries are named.
HSAs are incredible investment instruments.
No other investment asset enjoys the potential of triple tax savings like an HSA.
But HSAs are, at best, a second-rate financial legacy tool. The reason is the balance of an inherited HSA is 100% taxable to the heir in the year it is received.
Even taxable investments get better tax treatment for your heirs than that.
As you reach your latter years, be sure to take advantage of the tax savings HSAs provide for qualified medical expenses because you and your spouse are the only ones who can.
Furthermore, unexpectedly receiving a large inherited HSA would create an enormous tax liability for anyone.
It’s just better to spend down your HSA as much as you can while you’re still alive. In fact, it’s the only way to ensure any tax benefit is ever received by the funds in the account.
10) Stuff
Taxes: Not taxable unless the estate exceeds the lifetime estate exemption.
Probate Treatment: Passes through probate (if it’s recorded at all).
I wrestled with whether I’d rather inherit stuff or a completely taxable HSA.
I think it depends on what the stuff is.
Ultimately, most consumer goods you own are likely to also be owned in kind by your heirs. How many TVs, grills, couches, beds, and lamps do you think they need anyway?
In this way, material things become more of a burden than a benefit to your heirs.
Another issue with stuff is its value depreciates quickly after it is purchased and used.
For this reason, even HSAs taxed at marginal income tax rates are better than inheriting stuff because stuff will normally bring a fraction of its real value in an estate sale. Then the auctioneer gets their commission too.
Finally, there’s a hassle factor with stuff too.
Even if the number of heirs is relatively small there will likely be items in every estate that everyone wants, nobody wants, and a few things in between.
After you figure all of that out, do you have an obligation to call extended family and offer for them to come get what’s left? And how do you do that so that no one gets upset?
Then, what’s left (it’s appropriately called the residue of the estate) you have to either trash, donate, or try to sell, all of which take time and other resources.
I’m not painting a very rosy picture here, but there are certain items that carry sentimental value, monetary value, or both.
Things like jewelry, guns, fancy serving pieces, art, etc. may be items your heirs will be excited to receive, but remember to record your instructions for these items in writing.
To Do and Don’t List
In case you weren’t taking notes, here are some actionable items based on the information above:
Update your beneficiaries
Investment banks typically ask their clients to designate primary and backup beneficiaries in the case of their death.
These investment custodians will use this information to distribute your assets regardless of whether or not it aligns with your will and other estate documents.
So, make sure this information is given to your custodian and keep it up to date.
If you have kids, get married or divorced, or if you need to change beneficiaries for any reason at all, you need to update it with the custodian.
There are scores of unfortunate stories about fumbling this responsibility:
- Ex-spouses who receive IRAs from their former partner;
- Widows and widowers not receiving any inheritance because their in-laws were still the primary beneficiary on the account;
- Kids who were left out because mom or dad listed aunts and uncles are secondary beneficiaries decades earlier.
Go clean that up if you haven’t checked on it in a while.
Get Your “I’m Dead. Now What?” Packet Together
The location of your worldly possessions and assets may seem obvious enough to you, but this isn’t necessarily the case for your heirs or your executor.
Don’t assume they’ll know where to look, how much is in each account, or which accounts are still opened or closed.
Make a list of all your accounts on one page (or as few as possible) with account numbers, bank addresses, any relevant names, and the latest balance, and store it with your will or other estate documents for your executor to find.
Once you have this list, update it annually to lighten the burden on your executor as much as possible.
Don’t Add Your Heirs as Co-Owners of Property or Accounts
There are two reasons you shouldn’t add beneficiaries as co-owners to your major assets or your other accounts.
First, your heirs won’t receive a step up in tax basis when you die because they already legally own the asset. This creates a tax liability for them they could have avoided by inheriting the asset(s).
Second, if they co-own the asset, the asset is subject to any judgments or liens that might be placed against the property of your beneficiary.
For example, if you decide to add your son to your savings account and he’s sued because his dog bites the neighbor, your savings account is vulnerable to any judgments against him.
This would be true for your home too if you decided to add him to the deed.
There are other mechanisms for delegating power to manage assets to your heirs.
Go Read Our How to Leave an Inheritance Post
There’s a lot more to preparing your estate for your heirs than prioritizing how the assets are consumed.
Go back and read our How to Leave an Inheritance post to learn more.
