Inheriting a large sum of money can solve a lot of financial problems, but it can also create a few.
With a new inheritance, you’ll probably face some difficult choices. You’ll get a lot of conflicting advice, and you may discover some potential tax snares.
And, no matter how you use your inheritance, you may also feel like you’re always missing out on a better use for the money.
Everybody’s inheritance scenario is unique, and if you have specific questions you should seek professional advice tailored to your situation. But we can also discuss some basic principles for how to incorporate an inheritance into your life.
What is an Inheritance?
As you already know, you receive an inheritance from a family member who dies or chooses to transfer resources to his or her heirs before death.
For millennia, cultures have established norms for transferring wealth from one generation to the next.
Of course, an inheritance can also come from more distant relatives or friends since estate planning gives a property owner control over dividing and distributing his or her estate.
What Forms Can an Inheritance Take?
How to use your inheritance will depend a lot on the form it takes. While there are many ways to transfer assets, most inheritance comes through one of the following:
- Cash: You may receive a check from the executor of your deceased family member’s estate.
- Real Estate: If your family member owned property, you may receive the deed to a piece of property in full or partial ownership.
- Investments: You could receive bonds or stocks as inheritance. You may also receive certificates of ownership for gold or other commodities. You could even become the owner of your loved one’s IRA.
- Trust Fund Shares: You could become the part owner of a trust which holds assets and has an appointed manager who oversees and distributes funds to shareholders.
- Other Property: You could become the owner of valuable collectibles such as antique vehicles or rare coins.
Some forms of inheritance can create more complex tax scenarios for the recipient. Other forms can be difficult to liquidate. Some forms have more opportunities for growth if you leave them alone.
Regardless of your situation, it’s your responsibility to make the best decisions for yourself and your own heirs.
Inheritance Decisions: Take Your Time
Everybody I’ve asked about incorporating an inheritance into your financial life gives this advice: Take your time before making any big decisions.
How much time you’ll need can vary, but most people suggest taking at least a few months. That way you can have some time and space to consider the best use of your inheritance.
Give yourself enough time to get accustomed to the idea of having more resources and financial flexibility.
And you can also take this time to grieve if the person who left you the money was a close relative whose death affected you emotionally.
Asking for Help
Here’s another piece of consistent advice from advisors: Don’t go it alone, especially with a larger inheritance. You could make mistakes that will cost you at tax time.
You could also miss out on opportunities the inheritance presented.
Financial advisors can offer reliable guidance, especially if you already have a relationship with an advisor who knows your ideals and goals.
If you don’t have an advisor, find someone you can have a conversation with and someone who isn’t trying to sell you financial products.
Avoiding Tax Problems From an Inheritance
Financial advisors can help you understand the tax implications of your inheritance, but if you have a particularly complex financial life, you may want to seek the help of a tax advisor.
While you probably won’t have to worry about federal estate taxes since they would have been levied before you received the inheritance, your state may assess inheritance taxes on your share of the estate.
And although your inheritance shouldn’t be taxed as income, you may need to pay capital gains taxes if you inherited an income-producing investment.
Also, if you inherit a traditional IRA from someone other than your spouse, you’ll need to pay taxes on withdrawals, whether you withdraw the money in a lump sum or gradually throughout the rest of your life.
Before spending your inheritance, take at least a few minutes to look into taxation, and be sure to ask questions to avoid surprises on your tax return.
Setting Goals for Your Inheritance
Once you have access to your inheritance, money set aside for taxes if necessary, and a clear head for making decisions, it’ll be time to consider how to use your inheritance.
You’ll probably get a lot of advice. Friends or family members may share their ideas. Your children will have plans which will probably differ from your financial advisor’s thoughts.
But you — along with your partner or a friend if you choose — get to decide the best way to use the inheritance.
Many people’s ideas fall into the following categories:
With debt levels higher than ever, just about everybody could use some help paying off bills. Credit cards, student loans, car payments, mortgages, second mortgages — your inheritance could go a long way to relieve these kinds of debt.
This plan has the added benefit of freeing up money you’re currently spending on debt management each month which could help you work less and spend more time with family or on hobbies.
And being out of debt feels great.
A couple down-sides and pitfalls to avoid, though:
- Avoid Re-Immersion: This happens all too often: Someone gets out of debt and uses the flexibility to get right back into debt. You probably won’t have a second inheritance to help you out again.
- Some Debt is OK: Not all debt is terrible. Yes, you should get rid of high-interest credit card debt quickly to avoid exorbitant interest charges, but being in debt on real estate makes more sense. The property should hold its value or become more valuable while you’re paying it off.
Some people even argue you’re better off keeping the mortgage since you can write off the mortgage interest you’re paying each year on your taxes.
But if you’re determined to pay off the house with your inheritance, that’s not a bad thing. It would be great to own your home outright and have the freedom to sell it or improve it even more.
Saving for the Future
If you’re already out of debt or don’t want to spend your inheritance on debt relief, you may like the idea of saving as much of your inheritance as possible and even having your savings grow:
- High-Yield Savings Accounts: Several online-only banks now offer high-yield savings accounts with rates significantly higher than what you’d find at a neighborhood bank branch. Your money would grow a lot faster in this kind of account.
- CDs: To unlock even higher savings rates, consider certificates of deposit (CDs) from an online or neighborhood bank. To get higher rates you have to agree to leave your money alone for the entire term of the CD, and longer term CDs typically earn higher rates. If you don’t plan to use the money anyway, this won’t be a problem.
- IRAs: If you don’t already have a retirement plan, your inheritance may be just the catalyst you need to get it started. Putting money in an Individual Retirement Account (IRA) can also have tax advantages, either now or later in life when you withdraw the funds.
If you don’t already have three to six months of living expenses set aside in an emergency fund, you should use your inheritance to fund such an account before making other plans.
Interested in getting started with investing? Your new inheritance may also be just the chance you’ve been waiting for.
Solid investments can make your inheritance grow even faster. You could also erode your inheritance by making poor investments, so do some research before diving in.
- Just Starting Out: Beginners should consider more passive products such as exchange-traded funds (ETFs) or mutual funds which track broader indexes. When you’re ready to buy individual stocks, look for the right broker.
- Automatic Opportunities: Robo-advisors such as M1 Finance, Betterment, or Bloom do the investing legwork for you. They make investment decisions for you using parameters you established.
- Crowdfunding: You may want to invest part of your inheritance in real estate through Fundrise or another crowdfunded real estate site.
- Your Own Property: You could also use your inheritance to buy and fully own real estate in your region, either to develop or to hold onto which can diversify your portfolio.
- A New Business: Maybe you’ve had a business idea but never had the money to get it up and running. Your inheritance could provide the funds. Just be sure you have a solid business plan and the determination to make it work.
Your inheritance may represent the life’s work of someone you loved and cared deeply about. If so, sharing the money with others may seem like the right thing to do.
- Establish a Scholarship: If your deceased loved one was a teacher or a police officer, you may enjoy starting a scholarship fund to help future people get the education they need to start a similar career.
- Start a Foundation: A large inheritance could provide the funding for a foundation which could make life better for people in your community or region. Foundations do all sorts of good behind the scenes.
- Give to a Charity: Maybe you already support a non-profit or charity in your community. Money from your inheritance could help you provide even more support.
Helping others by giving away money can be a meaningful experience for the giver and the recipient. But you’ll need to plan your giving. If you feel obligated to give to any and every cause, you can get overextended.
A giving plan can help focus your philanthropy and optimize its impact.
With so many honorable and sensible ideas for an inheritance, some people forget the obvious: You could use your inheritance to buy something you’ve always wanted.
A pool, a vacation home, a more reliable car, a boat, new furniture — there’s nothing wrong with treating yourself with part of your inheritance.
But remember: You can quickly get overextended when you consider property taxes, maintenance, insurance, and other responsibilities of owning more property.
As with giving, creating and sticking to a spending plan can prevent you from going too far.
An Inheritance Should Power Your Ideals
A sudden influx of cash or other resources from an inheritance can be overwhelming. Suddenly you’ll have the freedom to say yes to your own dreams. You may even feel obligated to say yes to the dreams of your friends.
But not every dream can become a reality. Sadly, too many people squander their inheritance by spending too much, becoming overextended, and failing to think about the bigger picture.
What is the bigger picture? It’s painted by your ideals, your values, and your goals. Make sure these things shape the freedom your inheritance can provide.