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 could likely include making a long-term plan for your age and goals, starting with a well-stocked emergency fund and employing tax-advantaged investments if available. A financial advisor is a great way to develop a realistic long-term plan and lay out some strategies for reaching your goals.
Inheritance Strategies
The Federal Reserve’s Survey of Consumer Finances found that the average inheritance in the United States was $110,050. That’s up from the results of a 2006 research report which found that over an eight-year period, one in five American households, including older workers, got an inheritance averaging $67,000. But most spend their inheritance 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. So the first thing to do after receiving a sizable inheritance is to place the funds in a secure account. This could be as a 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 that include 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 for Investing Your Inheritance
Don’t be too stingy with yourself, though. 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. But after you have pampered yourself, you will have a number of options to build wealth, several of which offer distinct tax advantages and others that offer protection against inflation.
Tax-Advantaged Accounts
One of the best moves is to put the funds into aan individual retirement account (IRA) or Roth IRA or 401(k), if your employer offers one. 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.
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 in good shape.
Consider opening a health savings account (HSA) or maximizing your contribution to an existing HSA. The HSA maximum contribution for 2023 stands at $3,850 for individual coverage and $7,750 for family coverage. When you turn 55 years old, the IRS allows you to make additional “catch-up” contributions of $1,000 to your HSA. Federal law sets this static rate, so the IRS doesn’t adjust it every year for inflation.
Don’t forget about municipal bonds. The money an investor receives in interest payments and returned principal from municipal bonds, issued by states and municipalities, is free from federal income tax and, in many cases, from state and local taxes.
Inflation Hedges
The Series I Savings Bond offers robust protection against inflation. Through October 2023, it was offering a guaranteed 4.30% yield. You also should consider Treasury Inflation-Protected Securities (TIPS), a type of fixed-income security that the Treasury issues on a regular basis. The par value of a TIPS will increase in line with the Consumer Price Index (CPI) so as to keep the principal of the bond on track with inflation.
Equities generally offer a reliable haven during inflationary times. That’s because stocks historically tend to produce total returns that exceed inflation. And some stocks do better than others at fending off inflation. For 2023, equities of small-cap, dividend growth, consumer products, financial, energy and emerging markets companies are showing up on many recommended lists. Consider a diversified selection of index funds and low-cost vehicles with a long time horizon that often outperforms actively managed accounts.
Real estate is another tried-and-true inflationary hedge. Residential real estate, is traditionally seen as a reliable investment, but with mortgage rates in July 2023 hovering over 6%, it may be more challenging to get a good deal. Home construction and building materials are also getting recommended as inflation-busters. Real estate investment trusts (REITs), public companies that own real estate or mortgages, offer a way to invest in real estate without actually buying properties.
An investment in commodities can be one of the most powerful inflation hedges. Raw materials and agricultural products can be traded like securities. Commodities traders commonly buy and sell oil, natural gas, grain, beef, and coffee, among others. Investors can direct portions of their portfolios into commodities using futures contracts and through investments in exchange-traded funds.
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 inheritance, earnings from the funds are subject to income taxes. So tax-advantaged investments can be attractive for newly wealthy heirs, as can inflation hedges.
Tips on Handling Inheritances
- 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. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- 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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