Getting an inheritance can transform your financial situation, providing a significant boost to your financial stability. However, an inheritance can also be a source of stress. If your inheritance is mismanaged, it could leave your financial health unchanged, or even damaged. No matter how big or small the inheritance is, it should be treated with careful consideration and planning. In this blog post, we will explore some practical and strategic steps to help you navigate what to do with an inheritance.
1. Take time to make any major decisions
Before making any major decisions, take a step back and give yourself time to process the emotional impact of receiving an inheritance. Dealing with the loss of a loved one can be challenging, and it’s important to address any grief or emotions before deciding what to do with the inheritance. You don’t have to make any financial decisions straight away.
If you inherited cash, you could put it into a money market account or a high-yield savings account to accrue interest until you are ready to decide what to do with that money. If you inherited other kinds of assets, including stocks, bonds, retirement accounts, real estate, and business interests then you can work with the executor of the estate when you are ready.
(Don’t forget to download the ‘What Issues Should I Consider If I Experience A Sudden Wealth Event?’ guide if you haven’t already.)
2. Assess your financial situation
Take a look at your current financial situation and assess your existing assets, debts, and financial goals. You may want to create a budget to understand your monthly expenses and to identify areas where your inheritance could provide the most impact.
3. Understand the tax implications
Here are some of the main taxes related to inheritance that you need to be aware of.
- Estate tax: Estate tax is assessed on the total value of the money and the property in the estate and is paid to the government before anything is given to the beneficiaries. It is only assessed if the total value is above a certain amount. The value is based on the fair market value of the item on the date of the person’s death. It is the responsibility of the estate to pay this tax. In 2024, the federal estate tax is assessed for estates worth over $13.61 million for individuals and $27.22 million for married couples. Some states also impose an estate tax.
- Inheritance tax: This is a tax imposed on the assets or property you (the beneficiary) receive as an inheritance. It is generally based on the value of the inherited assets and varies depending on the relationship between the grantor and the beneficiary. As of 2024, this only applies to six states: Iowa, Nebraska, Pennsylvania, New Jersey, Maryland, and Kentucky. There are many exemptions to the inheritance tax so check with a tax professional to see if you owe an inheritance tax.
- Capital gains tax: A capital gains tax is assessed if the value of the item you inherited increases between the time the person died and the time you sell it. For example, if you inherit an asset, such as real estate, and later sell it, you may be liable to pay capital gains tax on the increase in value from the time of inheritance to the time of sale.
The rules and exemptions for state-level estate taxes vary widely, and not all states levy these taxes. It’s advisable to consult with a tax professional or a financial advisor who is familiar with the laws of your state, for accurate information on state-level estate or inheritance taxes.
4. Consult professionals
If you are inheriting a substantial amount of money, seeking professional advice is recommended. Financial advisors, accountants, and estate planning attorneys can provide valuable guidance tailored to your specific circumstances. They can help you understand the tax implications, legal obligations, and investment options associated with your inheritance. They can help you decide how to handle the money in the short term, as well as create a long-term financial plan that takes all of your assets and obligations into consideration.
5. Pay off high-interest debt
Consider using some of your inheritance to pay off debts, particularly high-interest debt, such as credit cards or personal loans. By eliminating these financial burdens, you can free up more of your monthly income for savings and investments.
If you have a mortgage, you may be thinking about paying it off. This will save you thousands of dollars in interest. However, it depends on the interest rate on your mortgage and the opportunity cost associated with having that money invested somewhere else. It is best to consult your financial advisor.
6. Build an emergency fund
If you don’t already have an emergency fund, then you should build one that can cover at least 3-6 months’ worth of living expenses. Consider keeping these funds in their own high-yield savings account where you can access the money quickly if needed.
7. Diversify your investments
When deciding how to invest your inheritance, diversification is key. Instead of putting all of your money in one type of investment, you may want to consider spreading those funds across various asset classes such as stocks, bonds, real estate, and mutual funds. By diversifying investments, you can mitigate risk and increase your chances of financial stability in the long run.
8. Retirement planning
An inheritance can significantly impact your retirement plans. Consider contributing a portion of your inheritance to retirement accounts such as an IRA, 401(k), or HSA.
- Individual Retirement Accounts (IRAs): Traditional and Roth IRAs are tax-advantaged retirement accounts that allow you to contribute a certain amount each year. The annual IRA contribution limit for 2024 is $7,000, or $8,000 if you’re age 50 or older. A traditional IRA offers tax deductions on contributions, while a Roth IRA offers tax-free withdrawals.
- 401(k) or Employer-Sponsored Plans: If you have access to an employer-sponsored retirement plan like a 401(k), 403(b), or 457 plan, you can use your inheritance to maximize your contributions. These plans often offer employer-matching contributions, tax-deferred growth, and higher contribution limits than IRAs. The 401(k) contribution limit for 2023 is $23,000 for employee contributions and $69,000 for combined employee and employer contributions.
- Health Savings Account (HSA): If you have a high-deductible health insurance plan, you can contribute to an HSA. HSAs provide triple tax advantages: contributions are tax-deductible, earnings grow tax-free, and withdrawals for qualified medical expenses are tax-free. The maximum contribution amount for 2024 is $4,150 for individuals and up to $8,300 for families. An additional $1,000 can be contributed by people over 55.
Everyone’s retirement plan will be different. It is important to choose a retirement plan that is right for your unique situation and financial goals.
9. Save for child’s college
You may want to consider allocating a portion of your inheritance to your child’s college fund. Finding the funds to pay for college can be a source of stress for parents. Using some of your inheritance can help lower this stress and alleviate the burden of massive student loan debt on your child.
Some options for saving for college include:
- 529 College Savings Plan
- Traditional Savings Plan
- Roth IRA
- Coverdell Education Savings Account
- Prepaid Tuition Plan
- UGMA or UTMA accounts
10. Gifting to charity
Individuals often find great satisfaction in supporting charitable causes with their inheritance. If you feel strongly about giving back to society, consider gifting some of your inheritance to charity.
11. Maintain financial discipline
Throughout the process, remember to maintain financial discipline. When you receive a large inheritance, you may be tempted to make an impulsive purchase or start to live a lavish lifestyle. However, you will reap great benefits from your inheritance if you use it wisely and keep your long-term financial plan in mind.
What should I do if I inherit a 401(k)?
Inheriting a 401(k) isn’t always as simple as inheriting a home or other types of assets. The IRS has detailed rules about when the beneficiaries must receive the 401(k) and how much tax they’ll pay. If you inherited a 401(k), we have a detailed guide to help you understand some of the important details that you need to know.
What should I do if I inherit an IRA?
Inheriting an IRA can be a generous gift but often people aren’t clear about the rules associated with it. There are different withdrawal rules and taxes depending on your relationship to the original account owner and whether the account is a Roth IRA, Traditional IRA, SEP IRA, or SIMPLE IRA. It’s important to understand all of the rules associated with an inheritance IRA so that you can plan an effective inheritance IRA strategy.
Gifting vs. Inheritance: Should I consider gifting over time?
You may want to consider gifting overtime to reduce the amount that your heirs will pay in inheritance tax. You can gift up to $17,000 per recipient per year for 2023 without having to file an IRS gift tax form. For example, a married couple with two children can gift each of those children $24,000 per year without impacting the parent’s lifetime gift exemption.
Should I use my inheritance to pay off my mortgage?
It depends. The general recommendation is to first pay off other high-interest debts, and establish an emergency fund. If you have done that, then it may be advantageous to pay off your mortgage. Compare the interest rate on your mortgage with the potential return you could earn on investing the inheritance. If the mortgage interest rate is low, you might be able to earn a higher return by investing the inheritance elsewhere. In contrast, if your mortgage interest rate is high, you may be better off paying it off.
However, for some, becoming debt-free is a priority. If owning a debt-free home offers you peace of mind, then it may outweigh other financial considerations. It’s a good idea to seek advice from a financial advisor who can provide personalized advice based on your specific circumstances.
Received an inheritance in 2023?
Receiving an inheritance presents both opportunities and challenges. By carefully considering your financial goals, seeking professional advice, and making informed decisions, you can maximize the potential of your inheritance. Whether it’s securing your financial future, investing for growth, supporting causes you care about, or a combination of these, making wise choices will allow you to honor the legacy of your loved one and create a lasting impact for yourself and future generations. If you aren’t sure what to do next and you are interested in a comprehensive financial plan, schedule a free discovery call with one of our financial planners today.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.