What to Do with an Inheritance

You’ve received a chunk of money from an inheritance. Maybe it was expected or maybe it wasn’t. Either way, you need a plan for how best to spend, save, and pay taxes on this money and other possible assets in order to ensure your long-term financial security.

Hiring an experienced financial planner, along with a CPA, lawyer, and/or tax professional, is a really good idea, but here are some basics to get you started or to help prepare you if you think you could be receiving an inheritance anytime soon.

Time to breathe

The first thing to do is take time to grieve your loss before making any life-altering decisions. Receiving an inheritance usually comes amidst strong emotions, including possible guilt at receiving something good at a time when other family members and friends are only experiencing sadness and pain.

To avoid making financial decisions while under the influence of warring emotions, wait to start spending or giving money until you have a plan with the input of experts—don’t quit your job, sell your house, buy new cars, or promise to pay for all of your nieces’ and nephews’ college expenses, yet.

Think about putting any cash you receive as part of your inheritance into a savings account or CD/share certificate for six months to a year. This gives you time to heal, set the rest of the estate’s affairs in order, and contact a team of finance professionals to help you.

Take stock

Once you feel you can assess your new situation with a clear head, it’s time to understand what you have inherited and what it can do for you—even a modest amount can help you reach your goals. Be clear on what your inheritance includes, how you can access those assets, and how to turn them into cash, if you want.

Oftentimes, an inheritance will include stocks, bonds, real estate, and/or retirement savings. Have a lawyer help you get those items switched over to your name as soon as possible.

Prioritize goals

Should you use your new wealth to travel? Renovate your house? Put it all toward retirement? Start your dream business? Give some of it away?

Prioritizing goals and then seeing how far your inheritance will go toward achieving them is the best next step because it will allow you to achieve more of them. Most financial advisors will recommend first paying off debt so you’re no longer losing money to interest. From there, ensure you have a sufficient emergency fund saved up. Next, retirement should be a priority, followed by other goals like paying for kids’ college, home repairs, travel, etc.

Taxes

There are different tax liability rules for different heirs—for example, spouses have some tax breaks and exemptions that aren’t available for adult children or other heirs—although the general rules below apply. Consult a tax professional before making decisions about your inheritance.

  • Estate taxes – Inheritors (i.e., you) won’t need to pay estate taxes; they’ll be paid to the government from the estate before you receive your portion of the inheritance.
  • Inheritance tax – Inheritance taxes are imposed after you inherit the assets. And while there isn’t a federal inheritance tax, several states have one. If you live in one of these states, you may still be exempt from paying it.
  • Income tax – Inheriting cash doesn’t count toward your income or your income tax liability. However, if you inherit something that produces income, you will probably need to pay capital gains tax on that income.
  • Investments in a taxable account – Things like stocks, mutual funds, or other investments in a taxable account are eligible for a tax break known as a “step-up in basis.” The cost basis for these taxable assets is “stepped up” to the investment’s value on the day of the original owner’s death. For example, if your great-aunt paid $30 for a share of stock and it was worth $280 on the day she died, your basis would be $280. This means if you sell the stock immediately, you won’t owe any taxes, and if you hold on to it, you’ll only owe taxes (or be able to claim a loss) on the difference between $280 and the sale price.

Another option would be to sell the individual stocks you inherit and invest the money in a diversified mutual fund, which wouldn’t trigger a tax bill.

  • Retirement accounts – If you inherit a tax-deferred retirement plan, you’ll pay taxes on that money (but spouses can roll the money into their own IRAs and postpone taxes and distributions until they’re 70½). If you inherit a Roth IRA and the original owner funded the Roth at least five years before their death, you don’t have to pay taxes on the money. If you don’t need the money right away, you can transfer it to an inherited Roth IRA and take required minimum distributions under the same rules of a traditional inherited IRA.
  • Real estate – Inheriting real estate is similar to inheriting stocks in that the value of the property will also be “stepped up” to its value on the date of the owner’s death. You have the option of selling the property, renting it out, or living in it. If you decide to live there for at least two years, you could then sell it and make up to $500,000 in profit from the sale ($250,000 if you’re single) without having to pay capital gains taxes
  • Life insurance – Proceeds from a life insurance policy aren’t taxable as income but may be included in your estate to determine whether you must pay federal or state estate taxes.
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