It’s not uncommon for people to receive sizable inheritances, but it’s less common for them to make the most financially advantageous decisions about what to do with their newly acquired assets. If you inherit a significant amount, such as $50,000, a strategy for wisely handling a windfall is likely to include making a long-term plan that considers your age and goals, starts with a well-stocked emergency fund and employs tax-advantaged investments if available. Consulting with a financial advisor is a great way to develop a realistic long-term plan and lay out some strategies for reaching your goals.
Over an eight-year period, one in five American households, including older workers, got an inheritance averaging $67,000, according to a 2006 research report. But most spend the money in a few years and have little left to show. A decade after getting an inheritance, the typical heir still has just a third of the windfall, according to a Swedish study from 2016. Here’s how to make an inheritance last.
Inheritance Strategies
The first thing to do after receiving a sizable inheritance is to place the funds in a secure account, such as a bank savings account or money market fund, while you take stock.
Whether you do it on your own or with professional assistance, create a sensible plan for handling the inheritance. Start with your current circumstances. Consider your age, income, assets and debt. Factors like your personal risk profile, future obligations such as children’s college and personal goals such as business ownership come into play.
Note that inheritances are not considered income by the IRS, so you won’t have to pay taxes on the money you inherit. However, any interest or capital gains on investments you make with the funds could be subject to taxes.
Before making any long-term investments, creating a rainy-day fund is likely to be a priority. Loading a secure, easily accessed account with three to six months of basic expenses can provide peace of mind while avoiding the need to borrow or tap illiquid funds in the event of an emergency.
Reducing high-rate debt could be next. Paying off revolving credit card balances will save more on interest than most investments can ever return. Getting into the habit of settling credit card accounts in full every month will prevent taking on more high-cost debt in the future.
Specific Options
After these priorities, much of the inheritance will be invested to build wealth long term. One of the best moves is to put the funds into a tax-advantaged account such as an individual retirement account (IRA) or 401(k). These accounts allow funds to grow without incurring taxes until funds are withdrawn, often after retirement when your income and tax bracket are both lower.
When choosing investments, either within a tax-advantaged retirement fund or a taxable personal brokerage account, a diversified selection of index funds will meet many investors’ needs. These low-cost vehicles with a long time horizon tend to provide equal or superior returns to actively managed accounts or stock trading schemes, while also minimizing taxes.
You can use a state-sponsored 529 college tuition fund to address children’s future education needs and, in some cases, reduce taxes. Bear in mind that funds placed in retirement or education accounts may be difficult to access in time of need, however. That’s why it’s a good idea to first make sure your rainy-day fund is well stocked.
Don’t be too stingy with yourself. Think about blowing some of the windfall on a luxury. Dropping 5% to 25% for a nice vacation or piece of jewelry can satisfy the understandable urge to pamper yourself with a little extravagant consumption while, hopefully, preserving the bulk of the inheritance for wealth building.
Other Inheritance Considerations
It can be tempting to use part of a windfall as a down payment on an installment loan to buy something that costs more than the total inheritance. This can backfire if the payments turn out to be more than you can comfortably bear. Use caution about leveraging inherited money to take on new debt, especially to acquire an asset unlikely to appreciate, such as a car. Making a down payment on a home you’ll occupy is often a wiser choice.
While owning a business is a good way to create long-term wealth, it pays to think twice before dropping a bundle of your inheritance into a new venture. Most businesses take a year or two to consistently generate profits. If the inheritance isn’t enough to keep the business going until it becomes profitable, it may be necessary to find other investors rather than risk losing your windfall in a failed venture.
When deciding what to do with your inheritance, consider family members and friends as well as yourself. It’s natural to want to help loved ones. But if word gets around that you’ve come into money, you may receive a blizzard of pleas for help. Thinking ahead about your capacity and desire to provide financial assistance can make it easier to say yes or no and feel good about it when the time comes.
Bottom Line
Before spending any of your inheritance, it’s a good idea to make a plan for how you’ll handle it. Some choices include creating an emergency fund, paying off high-cost debt, building up retirement savings, saving for kids’ educations and buying personal luxuries. While you won’t owe taxes on an inheritance, earnings from the funds are subject to income taxes. So tax-advantaged investments can be attractive for newly wealthy heirs.
Tips on Handling Inheritances
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If you have received or expect to receive an inheritance, getting help from an experienced financial advisor can make the difference between long-term prosperity and wealth that disappears as suddenly as it arrives. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
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It’s important to figure out how much you’ll need for your emergency fund. A free savings calculator can help with that task.
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