February 19, 2024

By Daniel Masuda Lehrman, CFP®, CSLP®

Navigating the Probate Process: Understanding How Inheritance Works

Navigating the probate process can be a daunting task, especially for those who are unfamiliar with how inheritance works.  Probate is the legal process by which the assets of an estate are distributed after the death of the estate owner or decedent. The probate process can take several months to several years to complete, depending on the complexity of the estate plan and the probate laws in the state where the deceased person lived.  Inheritance refers to the assets that a person receives from a deceased person's estate. If the deceased person had a living trust in place, the assets may pass to the beneficiaries without going through the probate process. However, if the deceased person did not have a living trust or a will, the estate may be considered intestate, and the assets will be distributed according to the probate laws.

During the probate process and timeline, an executor must file the decedent's will with the probate court, notify creditors and heirs of the deceased person's death, and file the decedent's final tax return. Any debts owed by the deceased person must be paid before the inheritance is distributed to the beneficiaries. It is advisable to consult with a probate attorney to make the process as smooth as possible and to avoid probate pitfalls. In some cases, heirs may only receive a portion of their expected inheritance after all the debts and expenses are settled.

What are the key terms related to inheriting assets?

  1. Probate: It's when a court makes sure things are distributed out correctly after someone passes away.
  2. Beneficiaries, Heirs, and Inheritors: These are the people who get stuff from someone who passed away, either because they were chosen or by law.
  3. Will: A paper saying who gets what after someone dies. If there's no paper, the law decides.
  4. Estate: All the things left by someone who died.
  5. Inheritance or Estate Taxes: Bills from the government after someone dies, sometimes paid from what's left behind.
  6. Trust: A special legal document saying who gets what from someone’s stuff after they die.
  7. Executor: The person named in the will to handle all the things left behind.
  8. Debts: Money the person who died owed. Before things are given out, these need to be paid, sometimes using what's left behind.

How long will the probate process take?

The probate process can take anywhere from a few months to several years, depending on the complexity of the estate plan left by the decedent. If the deceased person had a living trust or a well-drafted will, the process may be quicker and smoother. However, if the deceased person died intestate (without a will), the probate process can be more complicated and time-consuming. In general, the probate process and timeline involve several simple steps that the executor must follow to ensure that the assets of an estate are properly distributed. This includes filing the necessary paperwork, paying any outstanding debts or taxes, and ultimately transferring ownership of the assets to the beneficiaries. In some cases, a probate attorney may be hired to help guide the process to completion.

What Happens When There is No Will?

If the person who passed away didn't sort out who gets what before they passed, the probate court tries its best to figure out what the person wanted. They'll check if beneficiaries were named for stuff like stocks, bank accounts, and retirement plans.  Divvying up real estate, jewelry, and family heirlooms is trickier.  Once the court figures things out, they'll pick someone to handle it all (called an administrator) and divvy up the assets.  But this whole process can drag on for months or even years.‍

What Happens When There is Only a Will?

When someone passes away without a living spouse, their loved ones get what they leave behind through inheritance. Usually, it's a chunk of money for kids or grandkids, but it might also include things like stocks or property. All this gets sorted out when they plan their estate, writing up their will and picking who gets what.

The will is where it's all laid out—who gets what and how. If it's an even split among everyone, they just list the beneficiaries. But if certain stuff is meant for specific people, the will has to say that too.

To kick off the inheritance process, the will needs to go through probate. Again, that's when the court checks the will, picks someone to handle things (an executor), and then makes sure everything goes where it should as per the will. Before handing things out, the executor settles any bills the person who passed away still had.

What Happens When There is a Trust?

People often make trusts to give money or things to their kids or grandkids after they die. But they also use trusts to keep some of their money safe from taxes when they pass it on to others.  A big reason people like trusts is because they skip probate. Probate can be complicated, expensive, and take a long time.

But with trusts, there's no need for that. The person in charge of the trust can give things to the people who are supposed to get them without having to ask a judge first.

Want to know more about inheriting a trust?

Who Is Responsible for the Debts of the Estate?

Creditors might ask the family to pay the debts of someone who died, but the family isn’t directly in charge of them. The person handling the will or the estate pays off these debts using what's left, and then gives out the rest. So, if you inherit something, you don’t have to use your own money to pay those debts, and you should tell the creditors to talk to the person managing the estate.

Will You Owe Taxes on Your Inheritance?

When you are expecting an inheritance or have inherited assets, it is important to consider the tax implications that come with it. Depending on the size and complexity of the estate, you may need to consult with an estate planning attorney or a tax professional to understand the potential tax liability you may face.  Inheritances can be subject to various taxes, including federal estate tax and capital gains tax, so it’s crucial to plan for your inheritance accordingly. If you receive an inheritance, you may need to work with a tax advisor to ensure you are properly distributing and managing your assets to meet your financial goals.

Inheritance tax is charged in six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. These taxes might apply differently depending on who you are related to. Usually, spouses won’t have to pay this tax, but it might affect other family members. If you're not closely related to the person who passed away, you might have to pay higher taxes.

Inheritance tax and estate tax are different. Inheritance tax is paid by the person who gets the inheritance, while estate tax is charged on the deceased person's estate. Some states have both, while others have just one or none.

When you get a lump sum as an inheritance, it's not considered "income," but you might pay taxes if the assets you inherited make money. If you inherit things like stocks or property and later sell them for a higher value, you might have to pay a tax called capital gains tax. This tax depends on how much profit you make. Income taxes might also apply if you inherit a retirement account, except for inherited Roth IRAs and life insurance money, which are usually tax-free.

Inheriting an IRA

One common scenario is inheriting an IRA, which can have its own set of tax consequences. An inherited IRA may require you to pay taxes on distributions, so it’s important to seek tax advice in order to minimize your tax burden. Additionally, if you inherit a house or other valuable assets, you may be responsible for capital gains tax if you decide to sell them. Overall, understanding the tax rules surrounding your inheritance could significantly impact your financial plan and financial life.

  1. Traditional IRA: If you inherit a traditional IRA, the distributions you receive are generally taxable as ordinary income. The taxation depends on several factors:
    • If you inherit the IRA as a spouse, you have more options. You can treat the inherited IRA as your own by rolling it over into your own IRA or electing to treat it as an inherited IRA. If you choose to treat it as your own, you won't have to take required minimum distributions (RMDs) until you reach the age of 72 (as of 2024). If you choose to treat it as an inherited IRA, you'll need to start taking RMDs based on your own life expectancy or within ten years of the original owner's death if they passed away after December 31, 2019.
    • If you inherit the IRA as a non-spouse beneficiary, you generally have to start taking RMDs based on your own life expectancy or within ten years of the original owner's death if they passed away after December 31, 2019. The distributions you receive are taxable as ordinary income.
  2. Roth IRA: If you inherit a Roth IRA, distributions are generally tax-free if the original account holder held the Roth IRA for at least five years before their death. If you inherit a Roth IRA as a spouse, you have similar options to a traditional IRA, but if you inherit it as a non-spouse beneficiary, you're typically required to take RMDs within ten years of the original owner's death.

What if you inherit a house?

When someone inherits an asset, such as stocks, real estate, or other investments, the cost basis of that asset is typically "stepped up" to its current market value at the time of inheritance rather than the original purchase price.

The step-up in cost basis has important tax implications, particularly for capital gains taxes. Capital gains taxes are calculated based on the difference between the sale price of an asset and its cost basis. By stepping up the cost basis to its current market value at the time of inheritance, any appreciation in the value of the asset that occurred before the inheritance is essentially excluded from capital gains tax calculations.

Bottom Line

Receiving a big inheritance doesn't automatically mean financial security. It's common for people to struggle with a sudden windfall without a plan. Getting a lot of money at once might lead to spending too much or making hasty choices. Some who inherit money end up in a worse financial situation than before.

If you're expecting a large inheritance, it's crucial to be realistic about it. Check your current financial status and set clear goals. It's important to spend wisely, focusing on paying off debts and investing for the future.

Consider your priorities and what you want to achieve with the inheritance. Are there debts to clear or savings goals like retirement or your child's education? Many advisors suggest starting with an emergency fund, then paying off debts, and finally focusing on retirement savings.

About Daniel Masuda Lehrman

I am a Fee-Only Fiduciary and Founder of Masuda Lehrman Wealth LLC. Prior to starting my own firm, I was a Vice President Financial Consultant at Charles Schwab in their Downtown Honolulu office. I have worked in financial planning for 10 years at Vanguard, Fidelity, and Schwab. I'm a CERTIFIED FINANCIAL PLANNER™ professional (CFP®) and Certified Student Loan Professional with an Economics degree from the University of Michigan.

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