Take the time to make a financial plan before you spend your newly inherited wealth
Some people receive an inheritance so large it could upend their lifestyle, allowing them to retire early and live comfortably for the rest of their lives. But that’s not always common; the average inheritance in 2019 was $71,475, according to the Federal Reserve — not millions, but enough of a windfall to significantly impact your life. No matter how much you receive when a loved one passes away, here are a few key steps to take when considering what to do with your inheritance.
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You may not receive an inheritance immediately after someone passes away
Young people who receive a large inheritance can greatly benefit from hiring a financial advisor
It’s never too early to think about whom you want to receive your assets some day, and come up with your own estate plan
The first thing to do when you receive an inheritance is to take a step back and assess your financial situation. Though you may have the urge to spend your newfound wealth, act slowly and intentionally since most of the time there isn’t a rush for you to make any financial decisions.
People who receive an inheritance may want to hire a financial advisor, if they don’t have one already, to come up with a strategy. Professionals can help prevent you from spending too much or too little, and even help to grow your money. You can especially benefit if you don’t have previous experience dealing with high-value assets or a large injection of cash.
Coming into an inheritance can be an opportune time to pay off any outstanding bills, loans, or outstanding credit card debt. Even paying an extra large mortgage payment or paying your student loans schedule can help you get back on track and provide some relief.
Related article: 50 ways to pay off debt
When you receive an inheritance, there are three main circumstances under which you may face a tax liability:
If you inherit a house or any other real estate, you must get an updated deed to reflect that you’re the new owner. Typically the estate executor will help take care of that on behalf of the beneficiaries. Once the property is yours, you can live in it, rent it, or sell it. If you keep the house then you’ll have to pay property taxes, and if you sell the house you’re responsible for capital gains tax when the property is sold for more than the value at the time of the decedent’s death.
You must typically pay income tax if you cash in on retirement savings when the account was funded with pre-tax dollars (like with a traditional IRA or a 401(k)), so be sure to contact a financial advisor to help you figure out the best course of action. On the other hand, if you inherit a Roth IRA or 401(k) Roth, then you usually don't have to pay taxes when you withdraw money from it because the account was funded with after-tax dollars.
A retirement account that's made payable-on-death has specific rules about what a beneficiary can do, depending on the beneficiary’s age, how old the account holder was, and whether or not the account holder was receiving distributions at the time of their death. For example, you may be able to receive all of the funds as one lump sum, receive it incrementally over a certain period of time (as an annuity), or leave the money in the account for up to five years. You may also be able to roll over the account into an inherited IRA if the account holder was your spouse.
Learn more about a beneficiary designation versus a last will and testament
There is no inheritance tax at the federal level, but six states require people to pay taxes when they receive an inheritance from someone who lived in that state. If you are a surviving spouse or inherit money or assets under a certain amount then you may be exempt.
You can find out more, including specific tax rates, in this state-by-state guide to inheritance taxes.
Another tax that you may hear about is estate tax, which is levied on estates worth over $12.06 million 2022. Estate taxes are paid with estate funds (via the executor) before assets are distributed to beneficiaries — so while the estate tax can reduce how much you receive as an inheritance, you won’t be responsible for paying the tax itself as a beneficiary of the estate.
When it comes to managing inherited wealth, you can follow the usual money advice, by making sure you have an emergency account for unexpected expenses and saving towards certain financial goals. A few of the most common ones include paying for college (maybe through an UTMA or UGMA account), saving for retirement, and socking away money for a down payment on a home. Owning a home is one foundational way to build your net worth.
See how you stack up against the average net worth and wealth in America.
If you're investing your inheritance, you can try to diversify your portfolio with a different mix of low- and high-risk assets, or consider a mutual fund. “It is generally recommended you don't just invest in one company or one fund, and proper diversification can help decrease investment risk,” said Patrick Hanzel, certified financial planner and advanced planning specialist at Policygenius. “Speak with a financial advisor to decide what's best for you!"
The deceased person who left you an inheritance probably wanted you to enjoy it. After you’ve completed your savings goals and mapped out a plan, you may want to set aside some money to spend on yourself or even donate to others. Setting up a charitable trust can be a great way to create a lasting legacy in honor of the person who passed.
Learn more about how trust assets are distributed to beneficiaries
Many people receive their inheritance as a beneficiary of a will or trust. You can likewise plan for your future and what happens to your wealth by creating your own estate plan. Writing a will doesn't have to take long, and dying without a will means that state law will determine who receives your assets. To prevent that, you can make a will that outlines your wishes.
A will can also work well with a trust, a separate entity that holds assets on your behalf. Trusts can avoid probate and special types of trust can even help reduce your potential tax burden, which make them an important part of an estate plan.
You can get a state-specific will and revocable living trust with Policygenius
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