At some point in your life you may receive an inheritance from a loved one or friend. There are a number of issues you should consider first before making any spending decisions:
1 – Don’t rush into any quick decisions
You likely just lost someone close to you and, depending on the relationship, it could be a very emotional time. Relax, take a deep breath. There is no need to rush into making any quick decisions. Now is the time to evaluate and consider all of your options before moving forward.
2 – Diversify
It’s important to diversify any inheritance proceeds so they are in alignment with your long-term financial objectives. The person you received an inheritance from may have had a completely different tolerance for risk than you. For instance, you may have received a concentrated stock portfolio that is too risky for you. Or, maybe you received a heavy fixed income or bond portfolio which does not meet your long-term growth objectives.
3 – Consider taxes before diversifying
If you received after-tax assets (non-IRA), the inheritance likely received a step-up in cost basis. For example, your grandmother may have bought Walt Disney stock decades ago. At the time of her death the IRS gives the inheritor (you) a generous tax break and the new cost basis is the value of the shares at your grandmother’s death. Thus if you wisely choose to diversify your inheritance, there will likely be a minimal amount of capital gains exposure upon the sale of the inherited stock.
4 – Consider distribution options
Tax deferred assets such as an IRA or an annuity typically have a few distributions options such as a lump sum, 5 year payout or annual distributions to be paid out over your lifetime. Unlike after-tax assets, tax deferred assets do not receive a step up in cost basis. Also, most tax deferred assets are typically 100% taxable. Thus any dollar received via distribution will be taxed at your ordinary income tax rate. Depending on the amount of distribution, this could cause a fairly significant tax increase. You will want to work with your financial advisor and CPA before choosing any specific distribution option.
5 – Pay down debt
An unexpected windfall could provide a great opportunity to pay down high interest bearing debt. For instance, if you have credit card debt you may be paying interest in the 20% range. Student loans can also have interest rates in the high single digit range.
6 – Build up a cash reserve
A general rule of thumb is to have 6 to 12 months of expenses held in a liquid cash account. If you don’t have a cash reserve or emergency fund, an inheritance provides an opportune time to create one.
7 – Understand what can happen if you decide to mix your inheritance with the assets of your spouse or significant other
One of the common issues I see is those receiving an inheritance immediately commingle the assets with their spouse or significant other without understanding the ramifications of doing so. To commingle means to mix your inheritance assets with the joint assets of your spouse or significant other. As an example this might be a shared joint savings account, investment account or equity of your home if you were to pay off some or all of a joint mortgage. The concern and risk is that if you commingle assets with your spouse or significant other, and then sometime in the future you divorce or separate from them, you may now be forced to split your inheritance 50/50 with someone you no longer want to be a part of your life. The easy way around this issue is to keep your inheritance assets separate and in your own name.
8 – Do you have children from a prior marriage?
Similar to above, if you have children from a prior marriage, you may consider your inheritance family money with your children. In the event of you pre-deceasing your current spouse/significant other, you can ensure any inherited funds stay within the family and pass to your children as intended by keeping your inheritance funds separate from your partner.
9 – Update your financial plan
Depending on the amount of your inheritance, it could greatly change your financial life. This would be a great time to speak with your financial advisor to determine what changes, if any, will occur in your financial life by adding these additional assets into your total net worth and financial projection.
10 – Have some fun with your inheritance!
I purposefully put this last. It has been my experience that many inheritors start spending right away instead of thinking through all of the above issues. But after you have thoughtfully approached how your inheritance can be used in the most beneficial way to support your life goals, definitely make room for some fun. Go on that long awaited “bucket list” trip, splurge on something you have wanted for a long time, or invest in your favorite hobby.