Summary
- Set aside money for taxes, pay off debt, and build an emergency fund before you start investing money from your inheritance.
- You can use the dollar-cost average method if you’re worried about how the market will perform on any given date, but a lump sum investment may earn more if the market performs well from the get-go.
- Be aware of additional rules when it comes to inherited property, investment accounts, and retirement accounts.
- Investing an inheritance can be complex. Talk with a financial advisor to go over your most strategic options.
What to do before you invest an inheritance
Before you commit money to the markets, there’s some groundwork to cover first, including understanding the tax implications, paying off high-interest debt, and building an emergency fund.
Understand any tax implications
Because of the high estate exemption amount of $15 million per person, Inheritances generally aren’t subject to federal income tax. However, depending on the state you live in, you may owe a state inheritance tax.
Pay off high-interest debt
Paying off high-interest debt is a smart move to make with your inheritance. If you have credit cards charging 25% interest (or more), it makes sense to clear it out before you start investing. However, you may want to keep a mortgage with a 3% interest rate.
Build or top up an emergency fund
An emergency fund is a must-have in your financial arsenal. Take a look at what your monthly expenses are, and put aside three to six times that number for your emergency fund. Of course, you can put more if you want a larger safety net.
How to invest your inheritance
When you’re ready to put the remainder of your inheritance to work, you may be looking at how to go about doing it. Should you invest it all at once or in equal amounts over time? Your own goals and timeline may affect where and how to invest your inheritance.
Lump sum vs. dollar-cost averaging
The two approaches to investing you might consider include investing it all at once as a lump sum and investing over time with dollar-cost averaging.
With a lump sum investment, you invest the money all at once. If the market is favorable, you’ll benefit immediately. But short-term market conditions can be volatile, and putting your money in all at once could expose you to timing risks.
Dollar-cost averaging is the term used to describe regular investments over time. You invest a set amount of money, which is used to purchase investments whether the price is low or high.
It prioritizes consistency over market timing and reduces sensitivity to a single trade date, which is especially meaningful for investors with an inheritance.
Matching investments to your goals and timeline
Where you invest your money matters, and how long you invest before your own retirement matters, too. You may want to distribute your money among different types of retirement and investment accounts. Some options include:
- IRA: Retirement accounts have tax benefits, whether you save on taxes now with a traditional IRA, or when you take distributions in retirement with a Roth account. Retirement accounts can grow substantially if you have a long runway in front of you.
- Brokerage account: Brokerage accounts are taxable, but there are no withdrawal rules that limit you. With a brokerage account, you can benefit from your investments earlier than you would with a retirement account.
- HSA: A health savings account has triple tax-advantaged benefits. You save money on taxes when you contribute, the growth is tax-free, and when you take it out for healthcare needs, it’s also tax-free.
- 529 savings account: If you have a healthy retirement fund, you may consider investing money for a child’s education in a 529 account.
What if you inherited a house, retirement account, or investments?
Not all inherited assets behave the same way. A house, retirement account, or investment portfolio each comes with its own set of rules, which are especially impactful when it comes to taxes.
Inheriting a house or property: move in, rent, or sell?
When you inherit property, you benefit from a stepped-up cost basis, meaning the base value of the asset is set at the time you inherit it. One of the biggest benefits of this is you won’t pay capital gains taxes on the original value. If your parents bought a home in California for $100,000 in 1980 that is now worth $2 million, you won’t pay capital gains tax on the increased value.
However, what you do with the property changes what taxes you’ll owe and what value you can get out of it.
Moving in: The benefit of living in the property for two of the most recent five years is the home sale capital gains exclusion. If you wish to sell the property at a later date and benefit from the appreciation, this could be your move.
Renting: Renting the property may generate cash flow, but it does require a lot of time to get the property ready to rent and effectively manage.
Selling: If you sell immediately after inheriting it, you won’t owe much in capital gains since you’re selling at the value you inherited it at. Selling later means you’ll pay capital gains from the time you inherited it to the date of the sale.
Retirement account
Inherited retirement accounts have rules to follow, and understanding them can help you make tax-efficient decisions. They’re complex, so a tax accountant, attorney, or financial advisor is typically your best source of expertise. A few situations that may apply to you include:
- Generally, assets in a retirement account need to be fully distributed by December 31 of the 10th year you inherited the IRA.
- Distributions from Roth IRAs may be taken at any time, tax-free.
- Roth accounts must be at least 5 years old to benefit from tax-free earnings.
Rules are different for spouses inheriting retirement accounts than other beneficiaries.
Investment accounts
You benefit from a stepped-up cost basis when it comes to investment accounts. That means the original value of the asset is reset to the day you inherit it, and you don’t have to pay capital gains on the appreciation of the investment.
However, if you liquidate the accounts, there may be additional tax implications. It’s best to sit down with a tax advisor to go through your options.
Going forward is another story, and what you’ll pay in taxes will depend on the type of account you inherited. A brokerage account, for example, is taxable, but also offers greater flexibility when it comes to withdrawals.
Consulting with an expert is a must to understand the best move to make with the different types of inherited assets.
Common mistakes to avoid with an inheritance
Some common mistakes to watch out for include:
- Investing immediately while grieving: Without a strategic financial plan, you could put yourself in some bad positions. Seek professional advice for a comprehensive
- Ignoring tax implications: While inheritances generally don’t trigger federal income taxes, you may see estate taxes when you receive $15 million or more. You may also owe state taxes, depending on where you live.
- Concentrating stock positions: You may like picking stocks, but there’s a real danger to a portfolio without diversification.
A financial advisor can help guide you through any of these issues – and more.
The bottom line
Knowing what to do with inherited money and assets is complex. You don’t have to do it alone. There are some great advisors out there who are able to tackle these problems with you.
Unbiased makes it easy to connect to a financial advisor. Answer a few questions about your needs, and you’ll be connected to a financial advisor today.