While receiving an inheritance presents a tremendous financial opportunity, it also offers a challenge as it usually means losing someone close. The emotional aspect of losing a loved one is hard enough; compounding the situation by not taking the proper steps with the inheritance can be devastating.

One study found that Americans save only ~50% of their inheritance. Another study found that roughly one-third who received an inheritance had negative savings within two years.

While alarming, it is important to note that the median inheritance is ~$69,000. That means many people inherit smaller amounts that get spent immediately or are used to pay funeral expenses.

While everyone’s financial situation varies, there are key steps to help determine what to do with your inheritance and avoid the mistakes that many heirs fall prey to.

Develop a Plan

If you have not done so, now would be a good time to sit down and develop a financial plan to address your goals. Having a concrete plan helps you keep moving in the right direction and avoid the temptation of spending the money.

An inheritance often prompts people to seek a financial advisor’s help since important decisions need to be made. Our Bethesda, MD fiduciary financial planning firm regularly helps clients by educating them on their options and the impact on their financial goals.

In addition, consider seeking the services of a CPA and an estate attorney to help ensure you have all your bases covered.

Your Inheritance Options

You may feel tempted to take immediate action with your inheritance. However, consider pausing for a few weeks to process your emotions and gather your thoughts.

Two areas should be addressed first:

Debt: Paying off high-interest debt (e.g., credit cards) or debts with variable interest rates should be a priority. While paying down all debt is never bad, it can be an inefficient use of funds. Paying off a mortgage may seem like a good idea, but with interest rates at record lows, consider whether you can put this money to better use.
Cash reserve: Having an adequate emergency fund can help you avoid falling into consumer debt. At the same time, it can make you more comfortable investing and dealing with market volatility since you have a safety net in place. The reserve should be in the form of a savings account or money market account.

Once debt and cash reserves are addressed, the focus shifts to investing. You’re likely to have short- and long-term goals, which means you’ll want to invest the money in various account types.

Taxable: This step involves investing liquid cash (i.e., non-retirement funds) with the goal of outpacing inflation while keeping the money liquid for short- and intermediate-term goals.
Education: For those who want to save for their kids’ education, investing in a college fund such as a 529 plan is one of many options.
Retirement: An inheritance creates an opportune time to boost retirement savings and contribute up to the IRS allowable max. If eligible, lump-sum funding a traditional IRA or Roth IRA could be another option. Many retirement accounts provide the benefit of tax-deferred growth, which can have a big impact over the long term.

Types of Inheritances and Taxes

Perhaps the most overlooked area for people who have received an inheritance is taxes. While there is no federal inheritance tax, federal estate taxes can be owed depending on the size of the estate.

In addition, six states levy an inheritance tax. A common misconception is that inheritance taxes are based on the beneficiary’s resident state. In fact, the taxes are based on the resident state of the deceased. It should be noted that your relationship to the deceased will determine how much you are taxed.

Depending on the account type, additional taxes could be owed. Your taxes will depend on what you inherited:

Cash: Inheriting cash typically comes with no tax consequences for you as the beneficiary. The downside of holding too much cash is that it’s yielding less than 1%.

Real estate: Generally, real estate is tax-friendly as you receive a step up in basis. The downside to real estate is the expenses that come with maintaining or selling the property.
- Tammy’s uncle passed away, and she inherited his home that he purchased for $50,000. The home was valued at $275,000 when she inherited it. Tammy receives a “step up in basis,” so whenever she sells the property, she’s only responsible for taxes on any amount above $275,000.

Investments/securities: Similar to real estate, you receive a step up in basis to the fair market value of the securities upon the decedent’s date of death. This provides tremendous tax savings if you inherit investments with large unrealized gains. (Note: This could change as part of President Biden’s tax plan.)
- Tammy’s uncle also purchased $25,000 of Apple stock in 1991. Upon his death, the shares were worth $275,000. Tammy’s cost basis is “stepped up,” and she only pays tax on any amount above $275,000 when she sells her shares.

Retirement account: Inheriting a retirement account such as an IRA provides several options. This is often where mistakes are made.
- Lump sum: A lump sum provides you with immediate access to cash. While this may seem tempting, it should be noted that the entire withdrawal will be taxed as ordinary income in addition to any other earned income—which could propel you to a significantly higher tax bracket. It should also be noted that Roth IRAs are not subject to income tax.
- Rollover: Your relationship to the decedent determines if the funds are rolled to an IRA (spouse) or a beneficiary IRA (non-spouse). Both options maintain tax-deferred status and grow without being immediately subjected to income taxes. But the accounts have different withdrawal rules, and it is important to note that the SECURE Act changed the rules for non-spouse beneficiaries who inherited an IRA in 2020 or later.

Life insurance: As with cash, life insurance proceeds are generally tax-free and tend to be for larger amounts. Given their tax-free nature, life insurance proceeds are regarded as one of the more tax-friendly inheritance vehicles.

The tax implications of an inheritance can vary, and knowing your options can help prevent you from paying unnecessary taxes today.

Charity

If you plan on donating a portion of your inheritance to charity, it is highly recommended that you look into a donor-advised fund.

A DAF not only provides you with an immediate tax benefit but also gives you the flexibility to decide when you will disperse the funds to the charities of your choosing.

Take Steps to Better Your Financial Position

For many, inheriting money is viewed as a “windfall,” and while the temptation to spend it is fun, taking the proper steps will put you in a better financial position and potentially allow you to leave behind a portion to your heirs.

Discuss your situation with a fee-only financial advisor.

Don’t take anything we say as tax or legal advice. We are not licensed as CPAs, tax preparers, or attorneys.

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