Congratulations, you've received an inheritance! But you don't know what to do next or how to use it to reach your financial goals. Should you park the lump sum in real estate -- or an emergency fund? Invest in stocks or seek a high-interest bank account? Will you face estate taxes? It's important to learn about your options for an inheritance and to figure out how to best deploy those dollars.
Failing to do so could cost you dearly. According to one study, about a third of those who receive an inheritance end up in the red after just two years.
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First steps after receiving an inheritance
First, do... nothing. Don't do anything with the money. Give yourself a little time to get used to having it, while you research your options and decide how best to proceed. Otherwise, you may do what lots of heirs do: Get excited and spend a big chunk of it quickly, often ending up with little to show for it.
Instead, perhaps park that money somewhere safe, such as in a short-term certificate of deposit (CD), a savings account, or a money market account. Think twice before making any sudden moves, such as switching to a new financial advisor or hiring a contractor to finish your basement. You can enjoy some or even all of your windfall, but you should have a thoughtful plan in place first.
When exploring your options, a great place to start is with your financial goals. If you didn't have goals before, you need them now. Here are some common ones:
- Paying off debt: If you're saddled with high-interest rate debt, paying it off should be a priority.
- An emergency fund: You should have one, stocked with enough money to support you for three to nine months.
- Down payment for a home: You may be hoping to buy a home in the coming years.
- Retirement savings: You'll likely need a big war chest to help support you for many years.
- College savings: You may need to save a $100,000 (or much more) in order to help your kid(s) through college.
- Other goals: You may want to save up for a fancy vacation, an addition to your home, a new car, a boat, or any of a number of things.
Think about what your goals are, and rank them by priority. Receiving an inheritance puts you in a terrific position to be able to make progress toward one or more of them, and perhaps even fully achieve one or more. If you don't have a good financial advisor to help you, consider hiring at least consulting one.
How inheritance works
Property can be passed on from one party to another in several ways. You might inherit property through someone's will bequeathing it to you, or you might receive it via intestate laws that govern what happens to someone's estate if he or she dies without a will. You can also end up with a windfall if someone has named you as a beneficiary for a financial account or insurance policy, or through a trust.
Here are some terms you may need to know that relate to inheritances:
- Beneficiary: A party that will inherit property or funds, having been designated to do so in a legal document (such as a will or trust) or financial account.
- Estate tax: On the federal level, the real estate tax is a tax on large estates that only affects a very small number of people. Some states have their own estate taxes.
- Executor: Sometimes called a "personal representative," an executor is someone named in a will and/or appointed by a probate court to carry out the wishes of someone who has died. He or she will typically manage a bunch of paperwork, closing out accounts, paying creditors, ensuring that assets are distributed as directed, and so on.
- Grantor: This is the person who has established a trust.
- Heir: An heir, strictly speaking, is someone who inherits property if there is no valid will. These days, the word is often used to describe someone inheriting property through a will -- but the proper term in that scenario is beneficiary.
- Inheritance tax: Whereas an estate tax taxes the actual estate, an inheritance tax is levied on those who inherit property. There's no federal inheritance tax, though, and few states have one, either.
- Real vs. personal property: Real property refers to real estate, and personal property is just about any other kind of asset that one might inherit.
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Types of inheritances
Inheritances come in many forms, but here are some of the most common kinds.
If you inherit cash, you probably won't face any taxes on it. If it came from a very large estate, there may be estate taxes levied, but those are paid by the estate, not the beneficiary. As of 2019, someone can leave up to $11.18 million ($22.36 million for a married couple) and not face estate or gift taxes.
A retirement account
If you inherit assets from a retirement account such as an IRA or a 401(k), you have several options, and you may want to consult a financial advisor before deciding just what to do.
Here are the IRA options, in a nutshell:
- You can take a lump-sum distribution of the entire account balance. Taking lump-sum withdrawals can result in taxes if they're from traditional IRAs or 401(k)s, just as withdrawals by the original account holder would be taxable -- since such accounts are funded with pre-tax dollars. Withdrawals from Roth IRAs will be tax-free as long as the account has been open at least five years. Still, it can make sense to leave the money in the account so that it can continue to grow.
- If the deceased account owner wasn't yet required to take required minimum distributions (RMDs) from the IRA -- RMDs enter the picture once one turns 70 1/2 -- then you can keep money in the account for up to five years after the owner's death.
- You can take minimum annual withdrawals from the IRA over the course of your lifetime, as determined by special IRS life expectancy tables.
- If you're the surviving spouse of the deceased, you can roll over the IRA into your own IRA, with regular IRA rules applying to it.
And here are the options for an inherited 401(k):
- You can take an immediate lump-sum distribution of the entire 401(k) account balance. If it's from a traditional 401(k), the distribution can result in taxes.
- If the deceased account owner wasn't yet required to take RMDs from the 401(k) (such as if he or she died before the age of 70 1/2, you can keep money in the account for up to five years after the death.
- You can arrange for a trustee-to-trustee transfer to an inherited IRA account.
- If the original account owner hadn't started taking RMDs, you can start doing so when you turn 70 1/2. If he or she had started taking them, you may be able to take them according to a schedule based on your lifetime, not his or hers. This can mean smaller RMDs if you're younger than the original owner.
- If you're the surviving spouse, you can roll over the original owner's 401(k) into an IRA in your own name. From that point on, it will be an IRA and will follow regular IRA rules.
Houses or other property
If you inherit a house, you have several options: You can live in it, rent it out, or sell it. There are pros and cons to each, and some tax implications, too.
- Live in it: Say goodbye to your rent or mortgage payments if you move into a home you inherited from a home you were renting or buying via a mortgage. This route can boost your monthly income if you're no longer making major housing payments, though you will be on the hook for property taxes, insurance, maintenance, repairs, and so on. If you're currently carrying a mortgage, you'll need to rent out that home or sell it, which can deliver another windfall in the form of your home equity balance. Having more income and/or a meaningful lump sum can help you make big progress toward some of your financial goals.
- Rent it out: This option will give you some helpful income every month, assuming the property stays rented. But being a landlord is not as easy as it may seem. Those rent checks aren't all gravy, as you're still responsible for property taxes, insurance, maintenance, and repairs. Plus, you have to deal with getting, keeping, and managing tenants, which isn't always easy.
- Sell it: If you sell it, you'll end up with a nice bundle of money that you can treat much like a cash inheritance.
Tax-wise, if you inherit a home that has appreciated in value since it was bought by the person who left it to you, you'll typically get to "step up" the cost basis. Here's a simplified example to show that works: Imagine that your uncle bought a home for $100,000 and it was worth $225,000 when you inherited it. If he had remained alive and sold it for $225,000, he would have a gain of $125,000, subtracting the sale price from his cost basis of $100,000. But you get to step up that basis. Your cost basis in the house will be its value when you inherited it -- $225,000. So you could sell it soon and face little or no capital gain tax on it, or if you sell it in the future for $300,000, your basis would be just $75,000.
Remember that there's a home sale exclusion rule in our tax laws that lets you exclude up to $250,000 of gain from taxes when you sell a home -- and that rises to $500,000 for a married couple. There are a few rules, though, such as your having had to have lived in the home for two of the past five years. You also should not have claimed the exclusion in the past two years. Keep this rule in mind as you figure out what your best move is with the home you inherited.
Why you should consult inheritance specialists
As you deliberate and decide what to do with your windfall, it's smart to engage the services of some professionals along the way -- especially if the inheritance is sizable. Some such folks might approach you, knowing that you've inherited assets, but it can be best to find pros on your own, seeking referrals from friends or looking up highly rated ones.
Some folks you might need include a Financial planner, or tax lawyer, a Certified Public Accountant (CPA), and/or an estate planning lawyer or professional. If you inherited real estate, you might need to deal with a good real estate agent. You might start with a good fee-only financial advisor. If you want to look up one in your area, click over to NAPFA.org.
With any of these professionals, don't expect them to just tell you what to do. Instead, they should be offering various options and coaching you on the merits or drawbacks of each, helping you decide what to do. They can also tell you what to expect from various options (such as tax implications) and how you can get certain tasks done. Ideally, identify a handful of each kind of service provider you need and then meet with potential financial advisors to see which one inspires the most confidence and seems like someone you can deal with comfortably.
Now let's move on to what, exactly, you might do with your newly inherited funds. For many people, the best move is to invest much or most of the assets. After all, that's how you'll be able to achieve your financial goals. Here's a review of some top options.
Inheritance investment options
A bank account is a fine place for your windfall when you first get it, but with interest rates rather low these days, leaving money in one for the long run isn't going to lead to much growth. Here's how a $100,000 investment would grow over time at 2%, which is the kind of interest rate that some savings accounts might offer, compared to a growth rate of 8%, which is what you might average when invested in stocks:
|Time Frame||Growing at 2%||Growing at 8%|
CALCULATIONS BY AUTHOR.
Of course, bank accounts are a much better choice when interest rates are high. Remember -- back in the 1980s, they were in double digits, offering more growth than you were likely to get elsewhere.
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If you come into a bunch of money, one way you might want to deploy it is in real estate. You might want to buy a home for yourself -- perhaps just paying off the mortgage you're currently carrying, or you might want to buy some rental property. Being a landlord isn't always easy -- or even lucrative -- but if you own the property outright, you're more likely to come out ahead with the rent payments you receive than if you had mortgage payments on the property, too.
Know that there are other ways to invest in real estate, too. For example, you might invest in real estate investment trusts (REITs), which are stock-like investments that you can easily buy into and sell out of -- unlike actual real estate, which can take longer to buy or sell. A REIT is a company that owns a lot of properties, collects payments from tenants and lessees, and pays its shareholders a dividend from its earnings. REITs often focus on a certain kind of property, such as retail, healthcare, office, and/or residential properties, among others. (There are even prison REITs.) Alternatively, you might look into mutual funds focused on real estate companies. That's a good way to spread your money across many real estate-related businesses. For example, consider the Vanguard Real Estate Index Fund (VNQ), an exchange-traded fund (ETF) focused on real estate, sporting a low annual fee of 0.12%.
For most people, the best way to grow your money over the long run is via the stock market. The way to do so aiming for the best possible returns is to devote a lot of time to learning about investing and learning about various companies and industries -- and then carefully selecting the most promising stocks, holding them, ideally, for many years while keeping up with their progress. Along the way, you'll learn how to make sense of balance sheets and income statements and cash flow statements -- and how to calculate estimates of various stocks' intrinsic values.
Clearly, however, that route takes a lot of effort -- and isn't even guaranteed to get you outsized returns. Instead, you might just opt for the investment that superinvestor Warren Buffett has recommended for most folks: index funds. They're up next.
But if you want to try learning more about investing in individual stocks, here are some places to start:
- Your Definitive Dividend Investing Guide
- A Beginner's Guide to Value Investing
- How to Be a Successful Value Investor
- How to Buy Stocks: Your 10-Point Guide
It's hard to argue with just sticking much or most of your inheritance in index funds. After all, they tend to outperform most managed mutual funds, which are run by very educated professional stock analysts and money managers. Consider: According to the folks at Standard & Poor's, as of the end of 2018, 89% of all domestic stock mutual funds had underperformed the S&P 1500 Composite Index over the past 15 years, and 92% of large-cap stock funds underperformed the S&P 500.
Each index fund tracks a particular index, giving you the approximate return of the index, less fees, which can be kept extremely low with certain funds. Index funds exist in the form of mutual funds or ETFs. The SPDR S&P 500 ETF (NYSEMKT:SPY), for example, tracks the S&P 500 index, which is made up of 500 of America's biggest companies that together represent about 80% of the entire U.S. stock market's value. You can go even broader with the Vanguard Total Stock Market ETF (NYSEMKT:VTI), which encompasses all of the U.S. stock market, including small companies, or the Vanguard Total World Stock ETF (NYSEMKT:VT), delivering the world market. You can balance out your portfolio with bonds via index mutual funds and ETFs, too. The Vanguard Total Bond Market ETF (NASDAQ:BND) is an option that can fit that bill.
Index fund investing is easy and cheap, and it delivers returns that beat many more expensive alternatives.
Fun ways to spend an inheritance
A last option for your inherited money is probably the one you thought of first: having fun with it. That's a perfectly reasonable thing to do -- especially if you're free of high-interest debt and have a well-stocked emergency fund.
Take a look at your big picture and see how you should best allocate these dollars that you were fortunate to have received. See how many financial goals they can help you meet, and then think about how you might spend some portion on fun -- perhaps a family vacation, a new car, or a big-screen TV.
Inheritances don't come around too often, and many people never receive one at all. So be sure to make the most of yours.
Please call Debbie Brassel if you would like to invest in real estate. I would be honored to help you.