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Are Your Family Legacy Assets Suitable for Your Retirement Plan?

Everyone addresses the importance of passing down beliefs and values. What about assets?

By Robert Klein, CPA

Numerous books and articles have been written about the importance of creating, celebrating, and preserving a family legacy. Many address non-financial aspects, including beliefs, values, traditions, and stories passed down from one generation to the next.

Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. The firm’s motto is Planning, Managing, and Protecting Your Retirement Income™. Bob is the creator of FINANCIALLY InKLEIN’d™, a YouTube channel featuring tax-sensitive, innovative strategies for optimizing retirement income. Bob is also the writer and publisher of Retirement Income Visions™, a blog featuring innovative strategies for creating and optimizing retirement income that Bob began in 2009.

Robert Klein

Tax planning strategies for preserving high-value assets such as a business or real estate for subsequent generations have been the focus of the financial side of family legacy planning. These strategies are designed to maintain control over how assets are distributed after death while minimizing income and estate taxes and protecting the assets from creditors.

Different Types of Family Legacy Assets

Aside from businesses and real estate, family legacy assets can include bank accounts, nonretirement and retirement plan accounts, personal property, and intangible assets. Real estate runs the gamut, from primary and secondary residences to commercial and residential rental property as well as real estate investment trusts, or REITs. A discussion regarding the inheritance of closely held business interests is situation specific, complex, and beyond the scope of this article.

Family legacy assets, or FLAs, are a sub-category of inherited assets. They are assets that have either been formally or informally designated by the original owner, or assumed by beneficiaries, to be kept in the family indefinitely. Original owners with high-value assets typically memorialize in their estate planning documents their desire to have specific assets, e.g., a commercial office building, kept in the family.

Sometimes the original owner simply discusses the importance of keeping a particular asset in the family with family members. This is often driven by a sentimental attachment to a particular asset, whether it be a painting or the stock of a public company for which he or she was a long-time employee.

Even when a particular asset isn’t designated as a FLA by the original owner, beneficiaries often assume that an asset they inherit is a FLA. This may be a faulty assumption in situations where the asset, e.g., highly appreciated real estate, wasn’t sold by the original owner due to the fact that she would have incurred substantial income tax liability.

Suitability of Inherited Family Legacy Assets for a Retirement Plan

When you inherit FLAs, it’s important to evaluate the suitability of each asset for your retirement plan. Just because you inherit a particular asset doesn’t mean that it’s appropriate for your circumstances, personality, and financial goals. What’s suitable for one individual may not be suitable for another.

The determination of financial asset suitability is best handled by a qualified financial advisor in conjunction with a tax professional. This may require a major revision of your retirement plan depending upon the type, complexity, and value of your inherited FLAs relative to your existing financial situation.

Factors to consider when evaluating an inherited FLA retirement asset:

  • Your retirement planning stage - accumulating or creating retirement income 
  • Importance of keeping the asset 
  • Length of time you plan to keep the asset 
  • Whether you would have purchased the asset if you hadn't inherited it 
  • Partial ownership of the asset and co-ownership considerations 
  • Net after-tax proceeds from selling the asset 
  • Annual after-tax income from investing net after-tax proceeds in an income annuity 
  • Liquidity, inflation, default, and opportunity risk associated with the asset 
  • Comfort level with the risks associated with the asset 
  • Knowledge and experience in managing the asset 
  • Management considerations if you do not want to manage the asset 
  • Financial obligations and expenses associated with the asset 
  • Current and projected income and potential disruptions 
  • Projected net annual after-tax cash flow from the asset and projected duration

If you inherit an FLA, you plan on keeping it indefinitely, and you have children who may inherit the asset from you, it’s important that you extend the suitability assessment to include your children. Once again, assuming that a particular asset is appropriate for your circumstances, personality, and financial goals doesn’t mean that it’s appropriate for one or more of your children.

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Consider Net After-Tax Proceeds When Evaluating Inherited Family Legacy Assets

One of the most important suitability questions that should be asked when evaluating the retention vs. sale of a particular inherited FLA is: What would be the amount of your net after-tax proceeds you would receive if you sold the asset?

Beneficiaries are often so focused on their attachment to FLAs that they either don’t ask this question, or don’t understand or minimize the importance of the fact that death is a unique opportunity to avoid or significantly reduce taxation on the sale of an asset that would otherwise result in a sizable tax liability in many cases. This is often the case with real estate.

For those unfamiliar with it, the tax code provides an income tax incentive for selling nonqualified, i.e., non-retirement plan, inherited assets whose value exceeds their original purchase price or cost basis. Common examples of nonqualified assets include real estate and other equity assets such as an investment portfolio that isn’t part of a 401(k), IRA, or other retirement plan.

When the owner of appreciated nonqualified assets dies, the purchase price or cost basis is “stepped up,” or increased, to their fair market value on the decedent’s date of death. This avoids or significantly reduces taxation on the amount of unrealized gain that existed prior to death. Income taxation can be eliminated on the sale of assets for married residents of community property states such as California as a result of the “double step-up in basis” that occurs at the death of each spouse.

Evaluating the Suitability of an Inherited Family Legacy Asset: A Case Study

Let’s take a look at suitability evaluation as it applies to inheritance of a family legacy asset. Let’s assume that John, age 68, and Sally, age 66, rent a house in Pennsylvania. John and Sally receive a fair amount of guaranteed income from John’s pension, Social Security, and a tax-favored fixed annuity. Sally has a sizable IRA that she inherited from her mother several years ago. John and Sally’s guaranteed income and Sally’s IRA required minimum distributions cover their current fixed and discretionary expenses. Neither John or Sally has or qualify for life or long-term care insurance due to various medical conditions.

John recently inherited a small beach house at the Jersey shore from his deceased mother. John’s grandfather and grandmother purchased the property 60 years ago as their primary residence when they were 65. The house was inherited by John’s parents who lived in Pennsylvania and maintained it as their vacation home.

The house has been the site of numerous family gatherings each summer since it was purchased by John’s grandparents. John and Sally have fond memories of many fun weeks at the Jersey shore with John’s grandparents, parents, brothers, sisters, children, and extended family.

The house, which needs constant repair, is currently worth $800,000. There’s no mortgage, however, annual maintenance expenses total $48,000, including real estate taxes of $32,000. John and Sally don’t plan on renting the beach house since it has traditionally been used by various family members most of the summer and the Jersey shore rental market isn’t strong the rest of the year.

Although John’s emotional attachment to the beach house is strong and John doesn’t want to disappoint his family, John and Sally realize that they’re unable to afford the annual upkeep associated with the house. They understand that there will be no income tax liability if they sell the beach house due to the step-up in basis.

Furthermore, the net proceeds, estimated to be $740,000, can be used to cover John and Sally’s increasing expenses, which are projected to begin exceeding their income in a couple of years as a result of inflation. Finally, John and Sally realize that the house proceeds can provide them with a potential nest egg that can be used to pay for long-term care expenses.

About the author – Robert Klein

Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob recently sold his practice to Fortitude Financial, a holistic financial planning firm based in Spokane, Washington, with an office in Newport Beach. He is the creator of FINANCIALLY InKLEIN’d™, a YouTube channel featuring tax-sensitive, innovative strategies for optimizing retirement income.