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Inheritances aren't all that common — only about 20 percent of U.S. households receive an inheritance — but that still leaves millions of people needing to decide what to do with their inheritance.
Here's how to invest your inheritance and make the most of it.
How to start investing your inheritance
So what is an inheritance? An inheritance is simply the passing of assets from one person to another after someone dies. These assets can include real estate such as a house, cash, investments, jewelry, and other valuables.
Inheritance assets can pass to either beneficiaries (people named in a will) or heirs (children or surviving spouses).
Receiving an inheritance, especially a large sum, can feel like winning the lottery. Fortune brings financial stability and new opportunities for you and your family. But it's important to approach this newfound wealth with care and a clear plan. Rushing into an investment or big purchase can have negative financial consequences. If you're ready to start investing your inheritance, consider the following:
Take your time and make plans
When you receive an inheritance, it's important to proceed slowly and carefully.
Evaluate your current financial situation and consider how your inheritance will fit into your life. It's essential to prioritize how you spend your inheritance. If you have high-interest debt, such as credit cards or personal loans, it's wise to pay that off first. The same is true if you have little or no emergency fund to cover about six months' worth of expenses.
After you have these bare necessities in place, consider investing the rest of your inheritance, which will help you build wealth you may not have achieved otherwise.
This means investing your money in a variety of stocks, bonds, and funds. You can also consider investing in additional asset classes, such as real estate, gold, cryptocurrencies, and other alternative investments.
Get advice if you need it
Investing inheritances can be complicated. For most people, it's especially difficult because they've never received an inheritance before, making the process unfair and emotional.
It's okay if you don't have all the answers. In fact, it may be a good idea to seek professional financial advice. A financial advisor can guide you through the process and help you avoid common pitfalls. They can also help you understand the tax implications of your inheritance and create a comprehensive investment strategy that aligns with your financial goals.
One step in this process is to restructure your investments to align with a strategy that fits your goals. The good news is that once this process is complete, you may be able to fully automate your portfolio.
When choosing an advisor, make sure they are fiduciary, have experience dealing with similar situations and offer a clear payment structure. This will ensure they have your best interests in mind and can provide unbiased advice.
What to do with inherited investments
Inherited investments are investment assets that are passed on to beneficiaries or heirs. So you may inherit individual stocks or bonds, or an entire investment portfolio that combines stocks, bonds, mutual funds, or ETFs. Some companies have equity sharing programs that issue company stock to employees as a retirement benefit.
An important thing to keep in mind about inherited investments is the potential tax implications. First, the good news is that taxes on inherited stocks are levied on the estate, so your heirs don't have to pay them. The investment you receive has a stepped-up tax basis, which means its original cost price changes to the price at the time of inheritance, avoiding capital gains taxes on appreciation during the previous owner's lifetime.
However, if you sell the shares, you will be liable to pay tax on any subsequent gains.
Another important consideration is required minimum distributions (RMDs) if you inherit an IRA from someone other than your spouse. In these cases, you must withdraw the entire value of the IRA over time. Also, if the IRA is a traditional IRA rather than a Roth, these RMDs are taxed as income. So inheriting a traditional IRA with a large balance could result in a large tax liability.
What to do with inherited real estate
Another common asset that is inherited is real estate, such as a home. Inheriting a home comes with its own set of benefits and challenges. Deciding what to do with the house isn't always easy, as emotions can run high and the home may have great sentimental value.
You have three basic options: sell your home, rent it out, or live in it. Each of these options has its pros and cons.
Selling a House
Selling your home has the obvious benefit of giving you cash up front, which you can use for any of the purposes mentioned above, such as paying off debt or investing. You can also use that cash to invest in other properties.
Plus, there's a graduated tax basis on inherited homes, so you don't have to pay tax on the entire value of the home. Instead, you only pay tax if the home sells for more than it was worth when you inherited it. So if it was worth $200,000 when you inherited it and you sell it for $250,000, you'd only pay tax on $50,000 of that.
Renting a house
Renting out an inherited home isn't much different than renting any other home. Renting a home is an attractive option because it can generate cash flow for you. Plus, this cash flow gives you additional diversification as you work to build your wealth.
But remember that a home requires maintenance and unless you hire someone to look after it, you’ll have to revisit the property. Taxes can also get complicated.
Living at home
If homeownership has always been something you've wanted but has never been financially viable, deciding to continue living in an inherited home may be a good option. Many banks require a large down payment before granting a mortgage, so living in an inherited home may be a way to get over this hurdle. But don't forget about the property taxes and seemingly constant maintenance costs that often come with homeownership.
Ready to invest your inheritance? Consider stocks, bonds, and funds
While you could theoretically hold onto cash or put any windfall you receive from an inheritance into a money market account, this isn't an ideal strategy.
To get the most out of your windfall, you should consider investing in stocks, bonds and funds.
If you don't have much experience investing, you might not know where to start, but first answer some basic questions:
- What is your risk tolerance?
- When will you need money?
Risk tolerance is how much risk you are willing to take in order to earn a return. The best investments require at least some risk tolerance. If a 10 to 20 percent drop in the value of your portfolio would cause you a lot of stress, lower-risk investments are probably better for you.
When you'll need the money is important for a few reasons. First, it can determine where the money should be kept. For example, money in a retirement account, with some exceptions, is generally subject to a 10 percent penalty if you withdraw it until age 59 1/2. So if you're contributing to a retirement account, you should generally contribute with money you won't need until that age.
But there's another side to time horizons: if you need your money within five years, high-risk investments are usually not a good idea, because depending on the timing, your investment could fall in value and take years to recover. Eventually, it could end up significantly higher than it was before it fell, but if your time horizon is short, you may not have enough time to wait for it to rise again.
That is the nature of low-risk and high-risk investments. Here is a brief explanation of these two types of investments.
- Low-risk investments: These investments are usually more stable and can offer moderate growth in the short term. They have less potential for long-term growth, but this doesn't matter if you need the money within five years. Low-risk investments include government bonds, high-quality corporate bonds, and money market funds.
- High risk investments: These investments are volatile and take time to grow. They are risky but offer the potential for growth over the long term. Popular high-risk investments include initial public offerings (IPOs), high-yield bonds, individual stocks, and cryptocurrencies.
How to minimize your taxes with tax-advantaged accounts
When investing inheritances, it's wise to use tax-advantaged accounts whenever possible. This includes retirement accounts such as Individual Retirement Accounts (IRAs), Roth IRAs, 401(k)s, and 403(b)s. Depending on the type of account, you may receive valuable tax benefits on either withdrawals or contributions.
Here are some quick benefits of tax-advantaged retirement accounts:
- Traditional IRA: Contributions are tax deductible and taxes on growth are deferred until you withdraw them, which are taxed as ordinary income.
- Roth IRA: Contributions are taxed as ordinary income, and earnings are tax-free when withdrawn in retirement.
- Traditional 401(k): Contributions are tax deductible and taxes on growth are deferred until you withdraw them, which are taxed as ordinary income.
- Roth 401(k): Employee contributions are made on an after-tax basis, qualified withdrawals at retirement are tax-free, and the account grows tax-free.
The biggest difference between Roth and traditional accounts is when your money is taxed. With traditional accounts, withdrawals are taxed as income. With Roth accounts, contributions are taxed as income. If you put your money in these accounts, not a penny will be taxed, even if it grows over decades.
There's been some debate about whether it's better to put your money in a Roth account or a traditional account, and it depends on your situation, so it's impossible to say one is “better” than the other. In general, if your income will be higher in retirement than it is now, a Roth account may be a better choice.
But there's one thing you can't predict: your marginal tax rate. If your marginal tax rate will be higher in the future than it is now, a Roth is your advantage. That's because with a Roth, you pay taxes now but don't have to pay them in the future. Of course, if taxes go down in the future, a traditional retirement account is the better choice. Since you don't know what your marginal tax rate will be in the future, all you can predict is your retirement income.
Conclusion
Receiving an inheritance can be daunting in many ways. You may receive a large amount of cash, investments, real estate, and other valuables all at the same time. This can make it difficult to know how to properly handle an inheritance. If you feel like you need help, don't hesitate to speak to a financial advisor. Inheritances can be a great boost to your finances, but only if managed properly. Using your inheritance to pay off debts, build up an emergency fund, and invest is probably your best bet.
Editorial Disclaimer: All investors are advised to conduct their own independent research into any investment strategy before making any investment decision, and please note that past performance of any investment product is no guarantee of future price appreciation.
