Receiving an inheritance can feel like a double-edged sword. While it’s a beautiful gift, it comes at a high price—losing a loved one.
Even though a sudden financial windfall may feel like a blessing, it’s also an immense responsibility. You want to ensure you use the money to its fullest potential and not squander it on things you don’t really need or add value to your life.
Turns out that’s quite a tall order. One study discovered that people only save about half of their inheritances, meaning they, unfortunately, spend the other half. Even worse, nearly 35% of heirs saw no change or a decline in their wealth after getting an inheritance.
It’s far too easy for a few dream vacations, a new car, and a fancy home upgrade to make your inheritance do a disappearing act. But what if you wrote a different story and used your inheritance to give yourself and your family a financial leg up?
First, Take A Breath
When you receive a lot of money, your first instinct may be to do something with it, even if you aren’t sure what that something should be yet.
But perhaps the best thing to do is take a step back and wait to make any significant decisions. It’s so challenging to see clearly when your eyes are fogged by grief. When you react from an emotional place, you may not make the best choices for yourself. Emotions are part of life and certainly part of money, but it’s beneficial not to make life-altering decisions in an emotionally-charged state.
In most situations, you won’t have to make an immediate decision about how to use the money, so take advantage of the time you have to grieve and process.
Once you feel more settled, you can consider your options for your inheritance.
Get Clear About What You Inherited
Inheritances aren’t one-size-fits-all; they come in many shapes and sizes.
When you feel ready to think more deeply about your inheritance, step one is to be clear about what you inherited—cash, investments, property, jewelry, a mix?
The options you have depend on what you receive, and you can use each of these elements in different ways. If you inherited the family house, your choices would look different than if you’re the beneficiary of a retirement account like an IRA.
To help make sense of your options, enlist the help of your financial team. You can consult your financial planner, tax advisor, estate planning attorney, etc., to help you get organized.
Understand Your Financial Responsibilities
One financial aspect of your inheritance that you might not consider is tax.
Do you have to pay taxes on your inheritance?
Well, it depends.
First, let’s clear something up. Estate and inheritance taxes are two different things. Your loved one’s estate would handle the estate tax, meaning they would settle that tab with the federal and state governments (if applicable) before any money passes to you.
But you, the heir, may have to consider inheritance taxes. There’s no federal inheritance tax, and only 6 states levy an inheritance tax—luckily, Kansas isn’t one of them. So most of you will only need to worry about taxes once you decide what you want to do with your inheritance.
Taxable events could include selling off some holdings in an inherited investment account, selling the family house, or taking distributions from an IRA or other retirement account. Here’s a snapshot of the tax treatments of common inheritance vehicles.
Selling A House
If you inherit the family property and want to list it for sale, you may have to pay capital gains tax on the profits.
When you inherit property, there’s a beneficial rule called a step-up-in-basis that allows you to calculate the capital gain using the property’s fair market value on the day you inherited it, not the day your loved one bought it, resulting in much more favorable tax conditions.
Say your parents bought their 5 bedroom house in 1970 for $200,000. When you inherit the property, the fair market value is $500,000. In this hot housing market, you close at $600,000.
Without the step-up-in-basis, you’d have to pay capital gains tax on $400,000. But with it, you only have to worry about paying capital gains tax on $100,000 of gain!
The SECURE Act changed the landscape for taxes and inherited IRAs. Previously, beneficiaries of inherited IRAs could stretch distributions out over their lifetime (the stretch provision), allowing them to be intentional about their cash flow and tax situation.
But the law removed the stretch provision for most non-spouse beneficiaries. Now, you have to remove all the funds in the account within 10 years. Since many people inheriting these accounts are in their peak earning years, it could significantly strain their tax liability.
If you inherit a Roth IRA (and the account has been operational for 5 years), your distributions will be tax-free!
Cash And Investments
If you inherit cash in a bank account or a death benefit from a life insurance policy, you likely won’t have to pay tax.
You start having to pay tax once the asset is transferred into your name and produces income. So, if you inherit a checking account, the initial amount isn’t taxable, but the ongoing interest it accumulates is. The same idea applies to investment accounts, rental income, and more.
Remember, it’s unlikely that you’ll have to pay a specific inheritance tax on your gift. Once you receive the inheritance and decide what you want to do with it, you’ll need to consider the tax consequences. A proactive tax plan can help you feel confident and secure about your tax responsibilities.
Let Your Inheritance Fill Your Cup
Now that you have a sense of your financial responsibilities regarding an inheritance, it’s time to think about what you actually want to do with this money.
Before you settle on one thing, ask yourself,
- Where can my inheritance bring the most value to my family’s life?
- How can I use this money in ways that align with my values?
- Is there a significant financial goal(s) this gift could help me achieve?
- How can I honor my loved one’s memory and legacy with this gift?
An inheritance is a unique opportunity to better your financial future. It’s important to consider all of your options with great thought, intention, and care. You want to use your inheritance in ways that set you up for success, like investing or paying off debt.
A little tip: try not to spend it all in one place. Splitting up your inheritance to serve a few high-priority goals is an excellent way to make a more considerable impact on your money and life.
Here’s a list of meaningful ways to incorporate an inheritance into your financial plan.
- Allocate a portion to help you pay off debt. Perhaps you’re so close to paying off your mortgage/car loan/personal loan/high-interest debt or would love the opportunity to refinance to a lower interest rate. Consider using some of the funds to help you get debt-free.
- Shore up your emergency fund. So many families had to dip into their emergency savings throughout the pandemic, and your inheritance could help flood that fund with much-needed capital.
- Save for retirement. One way to make your money work for you is to invest it strategically. Maybe you’ll use some cash to max out your retirement accounts or boost your brokerage contributions. The more intentional you can be about saving early, the better your chances of reaching your goals when you want to.
- Invest in yourself. You might have hit a point in your life or career where you want to make a significant change, like a career change, going back to school, starting your own business, moving closer to family, etc. You could use some of your inheritance to better your current situation and give you the freedom to make big changes.
- Fund other important goals. Would you like to put some of the money toward your kids’ college education? Funding a 529 plan or even Roth IRA can set your child up for success.
- Give to charity. It may also be a great idea to donate some of your inheritance to a charity, cause, or organization that means a lot to you and your late relative. When you make charitable giving a family tradition, every dollar carries so much meaning, hope, and promise.
Lastly, you can set some money aside to spend on something fun. Be sure to plan for your other goals first, so you don’t spend too much too soon. Make a plan that serves your goals, values, and vision for the future.
Honor Yourself and Your Loved One
Think about the most memorable gift you’ve ever been given.
What made it so exceptional wasn’t the contents but rather the thought and care of the person who gave it to you. Your inheritance is a valuable gift from a treasured loved one, and it’s important that you honor their legacy by using the gift thoughtfully.
Being intentional and purposeful with this windfall is a gift to yourself and your loved ones.
At Chladek Wealth, we’re passionate about comprehensive financial planning for families and can be your trusted partner as you navigate this challenging transition. Together, we can help you review your options and empower you to make the best choices for you and your family.
Schedule a call to learn more about how we can help you today.
The contents of this article are for general information and educational purposes and should not be construed as specific investment, financial planning, tax, accounting, or legal advice. Please consult with a professional advisor before taking any action based on the contents of this article.
All investment and financial planning strategies involve risk of loss that you should be prepared to bear. We cannot guarantee any investment performance whatsoever, and past performance is not indicative of potential future returns.