What to Do With an Inheritance

2 What to Do With an Inheritance

Receiving an inheritance from a family member can create a large windfall of cash, and with it, new financial opportunities. What you do with the money will depend on the size of the inheritance, your financial situation and your level of experience managing investments. But in any case, having a defined plan is vital to ensuring the money is well-used.

A financial advisor can help you make the most of your inheritance by assessing your financial circumstances and creating a plan for the future.

4 Options for What to Do With an Inheritance

If you receive an inheritance, what it makes most sense to do with it will depend on your current circumstances and financial situation. It is vital to take care of the basics, like paying down high-interest debt, before jumping ahead to things like investing or purchasing real estate.

1. Pay Down Debt and Bolster Emergency Savings

The first question to ask yourself upon receiving an inheritance is whether or not you’re truly ready to invest. If you have debt, especially high-interest loans or credit card bills, you probably aren’t in position to begin investing.

While paying down debt may not be as exciting as picking investments, it’s a logical and responsible way to use the money. Think of it as an investment in your future. By wiping out your student loan or credit card debt, you’ll free up hundreds, if not thousands, of dollars each month that you can then use in some other way.

If you’re already debt-free or have money leftover after paying off your debt, then it’s time to examine your savings. Experts recommend having three to six months’ worth of expenses saved in an emergency fund. Not only is it a prudent financial move but building an emergency fund can give you a sense of security and the confidence you need to start investing. You’ll know that no matter what happens to the money you invest in the future, you’ll have a safety net in the form of your emergency fund.

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2. Save for Retirement

Like paying off debt or building an emergency fund, putting your inheritance toward retirement may not seem like an exciting opportunity, but it’s a sound investment. A recent Schwab Retirement Plan Services survey found that 401(k) plan participants across the country now believe they must save $1.9 million for retirement. Yet, one in four Americans have nothing at all saved for retirement, according to a PwC report.

If you choose to save all or part of your inheritance for retirement, there are several ways you can do so. If you have an employer-sponsored retirement plan, like a 401(k) or 403(b), you won’t be able to directly invest the inherited money into your retirement account. Instead, you can use the inheritance to cover living expenses while increasing the amount of money from your paycheck you contribute to your retirement account every pay cycle. Alongside this, you could put aside money in an IRA as well.

As an example, say you inherited $50,000. In that situation, you could invest the money in retirement accounts over the course of two years by maxing out your annual 401(k) contributions and then adding the rest to a Roth IRA.

3. Open a Brokerage Account and Invest

While 401(k)s and IRAs are great vehicles for saving for retirement, they come with significant limitations. If you wish to withdraw your money from a retirement account (except for Roth IRAs) before age 59 ½, you will incur a hefty 10% penalty on top of income taxes.

If you have a more intermediate or short-term goal for the money, opening a brokerage account and investing the money yourself will provide flexibility that a 401(k) or IRA will not. You can open an account with companies like Fidelity or TD Ameritrade, and then buy stocks, bonds, mutual funds, exchange-traded funds (ETFs) and other securities.

If you’re just starting out, consider investing in index funds. These low-cost, no-hassle investment vehicles track a market index like the S&P 500 or Dow Jones Industrial Average. Instead of picking and choosing between different stocks or mutual funds, you can invest in an index fund and get wide exposure to an entire market.

4. Buy Real Estate

Using a portion of your inheritance, or all of it, to buy real estate can be another good use of the money. Like the stock market, home values have steadily increased over the years. According to Census Bureau data compiled by the Federal Reserve Bank of St. Louis, the median sales price of homes in the U.S. has grown by nearly 1,400% in the last 50 years (not adjusted for inflation). Investing in real estate is also viewed as an effective way to hedge against inflation.

But if you already own a home, consider using the inheritance money to pay off your existing mortgage. The benefits of this strategy are twofold: First, the money will instantly convert into home equity. This means that if you choose to sell your home, you won’t have to pay back the bank or mortgage lender. Second, like paying off high-interest debt, wiping out mortgage payments will free up a considerable amount of cash each month that you can then invest elsewhere.

Should You Hire a Financial Advisor If You Get an Inheritance?

If you’re unsure what to do with your inheritance or simply want an unbiased partner to help you create a plan for the money, hiring a financial advisor is likely your best option.

A fiduciary advisor who puts your best interests first can help you assess your financial situation and determine the best use for your money. Assuming you wish to invest the windfall, they can then create a portfolio that aligns with your risk tolerance and time horizon.

Then again, working with a professional comes at a cost. Many investment advisors charge for asset management based on a percentage of your assets under management (AUM). The industry standard for asset-based fees is typically 1%, meaning that if you have $100,000 under your advisor’s management, you’ll pay $1,000 in annual fees. Advisors may also charge separate, fixed fees for standalone financial planning services, but fee structures will vary.

Taxes and Account Rules for Inherited Assets

An inheritance can come in many forms, and each form is treated differently for tax purposes. Money you receive directly, such as cash from a bank account or life insurance proceeds, is usually not counted as taxable income when you receive it. That said, any earnings generated after the transfer, such as interest or dividends, are generally taxable going forward.

Investments held in non-retirement accounts follow a separate set of rules. In many cases, the value of these assets is reset to their market price at the time of the original owner’s death. This adjustment affects how capital gains are calculated if you sell the assets later and can reduce or eliminate taxes on gains that occurred during the original owner’s lifetime.

Retirement accounts require closer attention. Inherited IRAs and employer plans are subject to distribution schedules that depend on your relationship to the deceased and the type of account it is. For many beneficiaries, the account balance must be withdrawn within a set period, and distributions from traditional accounts are typically taxed as ordinary income. Roth accounts often offer different tax treatment but still have rules regarding the timing of withdrawals.

Property passed down through an inheritance is handled differently than gifted property. Homes and other real estate often receive a valuation adjustment at inheritance, which affects how gains are calculated if the property is sold. Income earned from the property after you take ownership, such as rent, is usually taxable in the year it is received.

In some cases, taxes may apply at the estate or state level. While federal estate tax affects only larger estates, several states impose estate or inheritance taxes at lower thresholds. Rules vary by location and can affect how much of the inheritance ultimately passes on to beneficiaries.

Bottom Line

Inheriting money or property can have a profound impact on your financial future, but making smart choices with the money is paramount. Before investing your inheritance, be sure to pay off all debt and establish an emergency fund. From there, you can invest the money in stocks or mutual funds through a brokerage account, buy property or save for retirement. A financial advisor can play an important role in this process, providing valuable advice and managing investments on your behalf.

Tips for Managing Your Inheritance

A financial advisor can be a valuable resource to help you handle a large inheritance. SmartAsset’s free tool matches you with financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
While most states don’t collect inheritance taxes, you may owe taxes on future capital gains you make from an inheritance. SmartAsset’s free capital gains tax calculator can help you determine how much you’ll potentially owe in capital gains tax upon selling assets like stocks or mutual funds.