Receiving an inheritance from a family member should be a blessing. But too often, it becomes a curse.
It’s estimated that $68 trillion worth of assets will pass down from Baby Boomers to younger generations over the next 25 years, and many of those heirs won’t know how to put their inheritance to good use.1 More than one-third of all inheritors see no change or a decline in their wealth after getting an inheritance.2
Did you catch that? Some folks see their wealth decrease after they inherit a financial windfall. I’ve seen too many people get an inheritance and then throw it all away. They go on a few vacations, buy a fancy new car, and before they know it, the money is gone and they have nothing to show for it.
What if they’d put some of that money toward eliminating their debt, funding their retirement, or paying off their mortgage?
Your inheritance has the potential to change your family tree forever—so make it count! Here’s my advice to help you make the most of your inheritance.
What to Do With an Inheritance: Before You Start
Here’s the deal: When a loved one dies, you’re not thinking clearly enough to make major financial decisions. The good news is, in most cases, you don’t have to make any major decisions right away. There is nothing wrong with letting your inheritance sit there for a while as you grieve.
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If you received a lump sum of money, park the funds in a money market account for a few months. Take a deep breath. Take some time to mourn. And then, when you’re ready, you can focus and develop a plan for your inheritance.
Honor Their Legacy
As you start thinking about what you want to do with the inheritance you received, it’s important to remember where it came from. I always encourage inheritors to think about all the hard work and sacrifice that went into making that inheritance possible. We’re talking about a person’s legacy here!
Keeping that top of mind will bring a sense of responsibility, accountability and intentionality to the situation and help you use your inheritance wisely.
Build a Dream Team
When you receive a financial windfall like an inheritance, all kinds of people come out of the woodwork to tell you what you should do with it.
That’s why you need to form a board of advisors, or a “dream team” of highly qualified professionals who can walk you through the inheritance process. Depending on the type of inheritance you receive, and how much you receive, you may need to seek counsel from several, or perhaps all, of the following:
a certified public accountant (CPA) or tax advisor
an insurance agent
an investment professional
an estate planning attorney
a tax attorney
a real estate agent
These people aren’t there to tell you what to do. They should be teachers who will sit down with you and help you understand all your options.
What Do I Do With a Cash Inheritance?
You should always do three things with money: give, save and spend. An inheritance is no different. And just like a monthly budget, it’s important to give every dollar of your inheritance an assignment.
I tell folks to use a pie-graph approach, which just means thinking about your inheritance as if it were a pie that you’re going to divide into slices. Now, how you slice up your money will depend on your unique situation and where you are in the Baby Steps. Here are some of the slices you might include as you decide what to do with your inheritance:
Give Some of It — No matter where you are in the Baby Steps, giving should always be part of your financial plan! Give 10% to your church or a charity of your choice.
Pay Off Debt — If you have any debt you’re trying to pay off, use part of your inheritance to fast-track your debt snowball. Eliminate as much debt as you can. If you can write a check and be debt-free tomorrow, do it!
Build Your Emergency Fund — Having three to six months’ worth of expenses saved in a money market account will help you deal with life’s big emergencies.
Pay Down Your Mortgage — Can you imagine having no more house payments? Using part of your inheritance to pay down your mortgage can move you closer to that finish line and save you thousands of dollars in interest.
Save for Your Kids’ College Fund — There are plenty of ways to cash flow college without using your inheritance. But if you’ve fallen behind on saving for your kids’ college fund, you could put some of your inheritance into an Education Savings Account (ESA), a 529 Plan, or a UTMA/UGMA (Uniform Transfer/Gift to Minors Act) to catch up.
Enjoy Some of It — It’s okay to set aside a small portion of your inheritance to have some fun, but the amount will vary based on where you are in the Baby Steps. If you’re in Baby Steps 1–3, it should be less than if you’ve got retirement taken care of and have more margin. Remember, you want to use this money wisely!
How to Invest an Inheritance
After you’ve maxed out the contribution limits for your tax-deferred accounts, like a Roth IRA or a traditional IRA, you might be looking for ways to invest the money you’ve inherited. I want you to look at investing that cash in two ways:
1. Good Growth Stock Mutual Funds
Invest in good growth stock mutual funds through an individual or joint taxable brokerage account. Spread your money across four different mutual fund types: growth, growth and income, aggressive growth, and international.
An investing professional can walk you through all your options. If you need help finding an advisor, check out SmartVestor.
2. Real Estate Bought With Cash
Depending on the size of your inheritance, you may be able to purchase a rental property outright. But hear me say this: If you don’t have enough money to pay cash for a rental property, don’t buy it. Never borrow money for a rental property. If you have the cash to spare, contact a real estate professional who can advise you on your options.
Slicing the Inheritance Pie
Let’s say you’re on Baby Step 4 (already investing a full 15% of your income for retirement), you have $60,000 left on your mortgage, and you have two teenagers getting ready to go off to college in the next few years. If you receive a $200,000 inheritance, here’s one way you might consider slicing that pie:
Pay off mortgage: $60,000
Save for kids’ college fund: $20,000
Invest the rest: $80,000
What if I Inherit a House?
There are three things you can do with an inherited house: sell it, rent it out, or live in it.
Inheriting a House: Sell It
Usually when someone inherits a house, it’s worth more than it was when the original owner bought it. If that’s the case, you automatically receive a "step-up in basis" to minimize your capital gains taxes if you decide to sell the house.3 Here’s how it works:
Let’s say your mom paid $50,000 for her house and it’s worth $175,000 at the time of her death. For tax purposes, the value of the home at the time she died becomes what you "paid" for it—that’s the stepped-up tax basis.
You decide to sell the house a year later, and it goes for $200,000. That means you would only pay capital gains taxes on the difference between the selling price and the stepped-up tax basis amount ($175,000), which comes out to $25,000.
Inheriting a House: Rent It Out
Renting out the house could become an extra source of income for you and your family and a great way to build savings, pay off debt, or invest for retirement. But renting out a house also comes with some potential drawbacks. The ongoing upkeep and maintenance, along with more complicated taxes, may be a source of costly headaches. You also have to decide whether to maintain the property yourself or hire a property manager to do it for you.
Discuss your options with a real estate pro who can guide you on what makes the most sense for your situation. Either way, don’t make the decision solely on emotion.
Inheriting a House: Live in It
If you inherit a house that’s paid for and decide to live in it, you’ll have no mortgage payment. That means you can make some serious headway on your financial goals with that extra cash!
Keep in mind, though, that moving into an inherited house means you’ll be taking on the financial responsibilities that come with homeownership. When the air conditioner breaks in the middle of summer, it’s on you to fix it! Not to mention you’ll also be responsible for paying property taxes as the new owner. If you don’t already have a solid emergency fund, use any extra cash to save up three to six months of expenses so you can cover anything that comes along.
Something else to think about: If you live in the house for at least two years, you can then sell it and make up to $500,000 in profit from the sale ($250,000 if you’re single) without having to pay capital gains taxes.4
I know that’s a lot of information to take in! If you’re confused or overwhelmed, I recommend working with one of our real estate Endorsed Local Providers (ELPs). They can take the stress out of figuring out what to do with an inherited house.
I Inherited a Car, Antiques, Jewelry and Other Items . . . What Do I Do?
Inheriting a lump sum of cash or a home may come with a lot of big decisions, but figuring out what to do with all the other stuff—like dad’s baseball card collection and mom’s favorite jewelry—can be even trickier.
Decide which items you want to hold onto and then find ways to sell the rest online or through an estate sale. Estate liquidation companies can reduce the stress of clearing out unwanted heirlooms by looking at what you have, writing you a check, and hauling everything away—all in a matter of days. You could also donate furniture, clothes and other items to those who need it most.
What About Estate Taxes, Inheritance Taxes and Other Taxes?
Alright, things definitely get complicated when it comes to taxes associated with an inheritance, but stick with me here.
The federal estate tax is a tax on the transfer of a person’s property after his or her death. The federal estate tax is only assessed on estates worth more than $11.58 million.5
As an inheritor, you’re not liable for estate taxes—your loved one’s estate is. And even if the estate is subject to estate taxes, you don’t have to worry about estate taxes as an inheritor because they are collected before the inheritance is passed to you.
Inheritance taxes are a different story. Those taxes are imposed after you inherit your loved one’s assets. There is no federal inheritance tax, but six states currently have one. But even if your loved one lived in one of those six states, many beneficiaries—including husbands, wives, children and grandchildren—are exempt from paying any inheritance taxes.6
When it comes to taxes, it’s easy to get in over your head really fast. That’s why you should include a qualified tax professional as part of your dream team. If you’re looking for advice you can trust, connect with a tax ELP in your area.
Make the Most of Your Inheritance
You’ll probably only get one inheritance. Use it wisely! Like we’ve talked about, this is definitely not a time to try to figure things out on your own. You need a dream team in place to help you make the most of your loved one’s legacy.
A good financial advisor will help you navigate the emotions that come with receiving an inheritance as well as help you understand all your options as you decide what to do with it. Our SmartVestor program is a free and easy way to get connected with qualified investing professionals in your area. Find your pro today!