Receiving an inheritance can be life-changing. The proceeds of even a modest estate can bring you new financial opportunities, especially if you were previously struggling to save due to the high cost of living. But it's critical to approach any financial windfall with careful consideration and a solid plan.
Here are 12 tips to help you manage an inheritance wisely so you can achieve your financial goals.
1. Don't Rush Into Anything
While it may be tempting to use your inheritance to indulge in big-ticket purchases, home renovation projects or FOMO investments, it's best to take a step back and reflect before making any financial decisions.
Start by assessing your current financial situation, including your debts and assets, and think about your financial goals. In the meantime, stash the cash portion of your inheritance in an FDIC-insured account that pays competitive interest, such as a high yield savings account, so your nest egg is safe and protected from a loss in purchasing power due to inflation.
2. Take Stock of Your Inheritance
Aside from cash, your inheritance might include investments or property, such as a home, car, jewelry, art or personal items. Keep in mind that you generally don't pay income taxes on inherited cash, investments or property when you receive them. For instance, there is no federal inheritance tax, and only Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania have a state inheritance tax, although spouses and often other close relatives are exempt.1 However, you may need to pay taxes on any subsequent earnings or profits from those assets, unless they come from a tax-free source. For example, if you inherit a home and decide to sell it, you'd pay tax on any appreciation on the property between the time you receive it and sell it.
3. Get Professional Advice
Depending on the size and complexity of your inheritance, it may be wise to consult a financial advisor, tax professional, appraiser or real estate agent who can provide valuable insights and guidance tailored to your specific situation. Even with a simple estate, the services of a fee-for-service financial planner can be a good source of objective advice on how to best make use of a lump-sum inheritance or life insurance benefit.
4. Pay Off Debt
No matter how big or small of an inheritance you receive, it's hard to go wrong by using a portion of it to pay off high-interest debt. Start with your most expensive debt—often unpaid credit card balances—and then look at other forms of debt, such as lines of credit, car loans, student loans or mortgages. By reducing your financial burdens, you'll achieve greater financial stability and improve your overall financial well-being. Plus, you'll save on interest payments in the long run.
5. Build an Emergency Fund
Another sensible strategy is to set aside a portion of your inheritance specifically for emergencies. This safety net can provide peace of mind and protect you from potential financial hardships—such as taking on additional debt or selling investments at a loss.
6. Maximize Your Retirement Savings
Similarly, your inheritance provides an excellent opportunity to boost your retirement funds. Consider maximizing contributions to tax-advantaged retirement accounts such as IRAs or employer-sponsored 401(k) plans.
7. Save for Your Kids' Education
If you have children, consider allocating funds from your inheritance toward their future education through a savings account, such as a 529 plan. These tax-advantaged accounts grow over time, helping ensure your children's future educational needs are met.
8. Choose the Right Savings Accounts
When deciding where to allocate your funds, carefully choose the right savings accounts to suit your financial goals. High yield savings accounts are ideal for emergency funds because they provide solid interest rates and allow for withdrawals at any time without penalty.
Certificates of deposit (CDs) usually offer higher interest rates for longer-term savings but are not as flexible. For tax-advantaged accounts outside of retirement or education savings, explore options such as health savings accounts (HSAs).
9. Buy a Home or Other Real Estate
If you've previously been unable to save up for a down payment, your inheritance may allow you to become a first-time homeowner and begin building real estate capital. If you already own a home, evaluate the potential benefits and risks of further real estate investments, such as rental properties or real estate investment trusts (REITs). Consult professionals who can provide guidance on selecting the right properties and managing them effectively.
10. Invest in a Risk-appropriate, Diversified Portfolio
If you plan to invest a portion of your inheritance, diversification is key to managing risk and maximizing returns. Explore various options, such as stocks, bonds, mutual funds or exchange-traded funds (ETFs). Consider your risk tolerance and investment horizon to create a well-balanced portfolio that aligns with your financial objectives.
11. Give Back
Consider contributing to causes that are close to your heart, or honor the memory of a lost loved one with donations to their favorite charities. Philanthropy can be a rewarding way to make a positive impact while benefiting from potential tax advantages. Research and support organizations that align with your values and passions.
12. Have Fun
Once you've devoted the lion's share of an inheritance toward debt repayment and your savings and investment goals, there may be room for a little fun—but splurge wisely. For example, it's best to avoid luxury items, such as expensive cars and boats, since they come with additional ongoing costs like insurance, maintenance and property tax.
The Bottom Line
Managing an inheritance requires thoughtful planning and informed decision-making. By taking the time to assess your goals, seek professional advice and make wise choices that align with your unique circumstances, your inheritance can become a lasting legacy that improves your life and the lives of others.
Tamar Satov is a freelance journalist based in Toronto, Canada. Her work has appeared in The Globe and Mail, Today's Parent, BNN Bloomberg, MoneySense, Canadian Living and others.
READ MORE: Managing Money After the Loss of a Family Member
Sources/references
1 How Do State Estate and Inheritance Taxes Work? Tax Policy Center. Updated May 2020.