Receiving an inheritance is often an emotional and transformative event. It can bring with it a mix of gratitude, grief, and uncertainty, especially if you’re not sure how to manage the new wealth. While it’s natural to focus on the emotions surrounding the inheritance, it’s also important to take practical steps to ensure that you handle it wisely, both for your own financial security and to honor the intentions of the person who left it to you.
If you’re expecting an inheritance or simply want to be prepared for the possibility, here’s a guide to help you navigate this event.
1. Understand the Tax Implications
One of the first things you’ll want to know is how your inheritance will affect your taxes. In the United States, the good news is that most inheritances aren’t subject to income tax. However, there are a few key exceptions and other tax considerations to keep in mind:
- Estate Taxes: If the estate is large enough, it could be subject to federal estate taxes. These taxes are typically paid from the estate itself before any distribution to heirs. States may also have their own estate taxes or inheritance taxes, so it’s important to understand the local laws in your jurisdiction.
- Capital Gains Taxes: If you inherit assets like stocks, bonds, or real estate, you may be subject to capital gains taxes if you sell those assets in the future. However, inherited assets often benefit from a “step-up” in basis, which means that the asset is valued at its market value on the date of the decedent’s death rather than its original purchase price. This can reduce the capital gains tax liability if you sell.
Consulting with a tax professional or estate planner early on can help you understand the specific tax obligations tied to your inheritance and prepare you for any financial decisions that need to be made.
Related: How to Protect Your Children from Their Inheritance
2. Take Inventory of the Inheritance
Once you’ve received the inheritance, take time to fully understand what has been left to you. Inherited assets can vary widely, ranging from cash and investments to real estate, businesses, jewelry, or even family heirlooms. Knowing exactly what you’re inheriting will help you plan accordingly.
- Tangible Assets: This may include properties like a home, car, or collectibles. Determine whether you want to keep these items or sell them for cash, and if they require any maintenance or insurance.
- Financial Assets: Inherited stocks, bonds, retirement accounts, and life insurance policies should be carefully reviewed. Ensure that you understand the current value, any beneficiary designations, and the potential tax consequences of liquidating or transferring these assets.
- Debts: Some inheritances may come with liabilities, such as outstanding debts or mortgage payments. It’s essential to assess the full financial picture to understand whether you need to address these debts before managing the inheritance.
Related: Liquidating Legacy: How to Sell Estate Assets At Auction
3. Create a Financial Plan
Before making any decisions about what to do with your inheritance, it’s crucial to take a step back and evaluate your current financial situation and long-term goals. An inheritance, especially a large one, can provide the opportunity to make significant strides in your financial planning, but it should be handled thoughtfully. Consider the following steps:
- Pay Off Debt: If you have high-interest debt (like credit cards or personal loans), using a portion of your inheritance to pay it off can provide immediate financial relief and improve your long-term financial health.
- Build an Emergency Fund: If you don’t already have an emergency fund, consider using part of the inheritance to build one. Having three to six months’ worth of living expenses in a liquid, low-risk account can provide peace of mind in case of unexpected events.
- Invest for the Future: If your immediate financial needs are met, consider investing a portion of the inheritance for future growth. Speak with a financial advisor to help you determine the best investment strategies based on your risk tolerance and financial goals.
- Save for Retirement: You may also choose to contribute to retirement accounts like IRAs or 401(k)s, especially if you’ve not been able to maximize contributions in the past. Inherited retirement accounts (like IRAs or 401(k)s) come with their own rules, so it’s important to understand the best way to manage them to avoid penalties.
Related: 5 Mistakes to Avoid When Hiring a Financial Advisor
4. Consider Your Estate Plan
Receiving an inheritance is a perfect opportunity to review your own estate planning documents and update them as needed. Just as your loved ones have made provisions for you, it’s important to ensure that your own assets are distributed according to your wishes when the time comes.
- Update Your Will and Trust: If you’ve received a significant inheritance, you may need to adjust your will or trust to reflect your new assets. If you haven’t already, now is a good time to establish or update a will and appoint beneficiaries for your assets.
- Review Beneficiary Designations: Make sure that beneficiary designations on accounts like life insurance policies, retirement accounts, and bank accounts are current. These designations override any instructions in your will, so it’s important they align with your overall estate planning goals.
- Create Powers of Attorney: Powers of attorney for financial and healthcare decisions are an important part of planning for the unexpected. Ensure these documents are in place to help manage your affairs should you become unable to do so.
Related: 5 Things You May Not Know About Estate Planning
5. Consider Charitable Giving
If the inheritance is substantial, you might want to consider charitable giving. Many people choose to use part of their inheritance to support causes that are important to them. Charitable giving can offer significant tax benefits, and it can also be a meaningful way to honor the memory of the person who left the inheritance to you.
Options for charitable giving include:
- Donor-Advised Funds (DAFs): DAFs allow you to contribute to a charitable fund and distribute donations to various charities over time.
- Charitable Remainder Trusts (CRTs): These trusts allow you to donate assets while receiving income from them during your lifetime and ultimately leaving the remainder to charity.
Consulting with a financial planner who specializes in philanthropy can help you understand how to maximize the impact of your charitable contributions.
Preparing for an inheritance means understanding both the emotional and financial aspects of the experience. By being proactive in your planning, you can ensure that you handle the inheritance responsibly, honoring both the legacy of the person who left it to you and your own financial future. Whether you use the inheritance to improve your financial stability, invest for growth, or support charitable causes, thoughtful planning will help you make the most of this valuable financial opportunity.
If you’re unsure about how to proceed, don’t hesitate to seek professional advice from a financial planner or tax advisor to help you navigate the complexities of inheritance and make decisions that align with your long-term financial goals.