Some estimates suggest that around $70 trillion in assets will pass down from older generations to younger generations in the next two decades. If you're on the receiving end of some additional wealth, planning to manage it and create greater long-term financial stability can protect your family and offer you greater flexibility.
Some studies suggest that one-third of people who inherit wealth end up worse off. The guide below will help you create a plan to protect your wealth and your future. Read on to learn what to do with inheritance.
Understanding the Basics of Inheritance
Inheritance is the process of receiving property, titles, assets, privileges and rights from another person after their death. Normally, inheritance refers to the assets the inheritor or beneficiary receives after the death of a family member or friend. Inheritance can include cash, savings, and investment accounts, as well as cars, jewelry, art, antiques, real estate and insurance policy death benefits.
Assets are divided according to the decedent's will and will go through the probate process. Generally, assets will cover any debts or liabilities before the remaining assets are distributed.
What should you do when you inherit money? Don't spend it all at once, and start making a financial plan. Remember that depending on the state you live in and the size of the inheritance, the inheritance may be subject to inheritance tax. Six states impose inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.
7 Smart Things to Do With Large Inheritance
When you receive a large inheritance, there are some basic financial steps to take to protect your future and ensure you end up better off financially after the inheritance. The first steps are the basis: Pay off high-interest debt like credit card debt and create an emergency fund. With that foundation, you can start planning for investing, college funds and other financial goals. Here's an overview.
Build an Emergency Fund
Creating an emergency fund ensures that when unexpected expenses crop up, you have the funds to take care of them without going into debt. From vehicle repairs to emergency medical appointments to a broken sink, an emergency fund can help ensure you're not over budget. An emergency fund can also carry you through a job transition.
How much you should have in your emergency fund depends on your income and expenses. Financial experts generally recommend having at least three to six months of expenses in savings. If you're in an industry where finding a new job can take longer, you could have up to a year's expenses in an emergency fund.
If you expect other big expenses, like a big medical bill, and you don't have other savings or insurance to cover it, keeping more in an emergency fund can help prepare for that as well. Keeping your emergency fund can help earn more interest while ensuring that the funds are insured by the Federal Deposit Insurance Corp. (FDIC) and easily accessible when needed.
Pay Off High-Interest Debt
High-interest debt can cost you 25% to 50% of its value in interest payments, especially if you only pay the minimum. That's why the first step after an inheritance should be to pay off all high-interest debt as quickly as possible. Start with credit card debt, personal loans and private student loans. Then, consider whether you can also pay off all student loans and a portion of your mortgage if you have one, especially if you're paying high interest rates.
Invest in Retirement Accounts
Putting the inheritance into tax-advantaged retirement accounts can help you increase your wealth over time. Consider maxing out any employer-matched 401(k)s, traditional individual retirement accounts (IRA) or Roth IRAs. These can help your investments grow tax-free. Learn more about how to invest for retirement.
Invest in Real Estate
Real estate is one of the most stable long-term markets to preserve generational wealth. In addition to increasing in proportion to inflation or growing asset value over time, if you invest in rental properties or other real estate, you can get extra short-term cash flow. Investing in rental properties you buy with cash or multiple properties with a large down payment with a mortgage could create positive cash flow from the first month.
Invest in Mutual Funds
Investing an inheritance can seem daunting if you don't have investing experience. A mutual fund invests in tens or hundreds of individual stocks, bonds and other assets. Mutual funds offer risk diversification to protect your wealth while providing access to different parts of the market. Mutual funds are professionally managed and offer a convenient investment method without worrying about picking individual stocks. In addition, most mutual funds have low expense ratios, meaning more of your wealth is being reinvested than spent on management fees.
Create a College Fund for Children or Grandchildren
One meaningful gift for a large inheritance is to create a college fund for your children or grandchildren. A tax-advantaged 529 college savings plan can help you save on taxes while preparing for your children's or grandchildren's future.
The average tuition and fees for in-state college tuition ranges from $4,541 in Florida to $17,593 in Vermont. Over four years of college, students can expect to spend an average of $40,000 or more on tuition and fees and at least as much for room and board. And that's assuming your children or grandchildren don't opt for private or out-of-state colleges.
Establish Financial Goals and Plans
In addition to retirement, emergencies and creating positive cash flow through real estate investing, consider other financial goals and plans. You can also consider creating your own business or planning for other big purchases. You can use part of the inheritance for a special trip or to buy a bigger home — as long as it fits in your overall financial planning. It can be worth working with a financial adviser or investment adviser to create a plan to not only preserve wealth but grow it over time.
Inheritance Tax and Its Implications
Inheritance tax is a type of capital gains tax that beneficiaries of an inheritance must pay if they cross certain thresholds. The estate of the deceased pays estate tax, while the recipient of the bequest pays inheritance tax. Federal estate tax returns are only required for estates with values exceeding $12.92 million in 2023, according to the IRS. There is no federal inheritance tax.
Inheritance taxes vary by state. Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania all charge an inheritance tax. The inheritance tax can be assessed by the state where the deceased lived or owned property.
Inheritance tax is usually on a sliding scale, starting in the single digits and increasing up to 18%. There are also exceptions. For example, in Iowa, spouses and lineal ascendants or descendants, meaning your parents, children and grandchildren, are exempt from inheritance tax. In Kentucky, all immediate family members are exempt.
Unless you or someone who plans to leave you a bequest lives in one of the states with inheritance tax, you'll automatically be exempt. If you live in a state with inheritance tax, you can check for exemptions or consider making a gift during your lifetime. You can also consider setting up a trust.
What To Do With a Large Inheritance
If you're wondering what to do with an inheritance, there's no right or wrong answer as long as you consider your whole financial picture. What to do when you inherit money depends on many factors, including any debts, your current income, and financial goals. One key in wealth management is diversification. Don't invest in a single place. Instead, divide the inheritance between financial goals or accounts, such as retirement accounts, high-yield savings accounts and other investment or brokerage accounts. Consider real estate, college savings and other financial goals.
Of course, you can allocate a percentage of the inheritance upfront or the income it generates in future years to a special splurge like a vacation, new car or other big expense. Remember to diversify, plan to save and create a strategy so the money you receive now can protect you in the future.
Frequently Asked Questions
Do you have to report inheritance money to the IRS?
You generally don’t need to report inheritance money to the IRS as it’s not considered taxable income. The IRS has an interactive guide to determine when your inheritance would be considered taxable to help you act appropriately for your situation.
At what age do most people inherit?
As life expectancy and family situations vary widely, there is no average age of inheritance. However, the majority of inheritances are received between the ages of 46 and 75.
Where should I deposit a large cash inheritance?
If you receive a large cash inheritance, consider the steps above. You can keep an emergency fund in a high-yield savings account, pay off debts and consider investing the rest in retirement accounts, real estate, mutual funds or other investment categories.
What should you not do with an inheritance?
In general, the most common mistakes when someone receives an inheritance are either to spend it all or to keep it in cash without using it to make more money. Instead, make a diversified investment and savings plan that can help secure your future and provide a financial cushion when needed.
About Alison Plaut
Alison Plaut is a personal finance writer with a sustainable MBA, passionate about helping people learn more about financial basics for wealth building and financial freedom. She has more than 17 years of writing experience, focused on real estate and mortgage, business, personal finance, and investing. Her work has been published in The Motley Fool, MoneyLion, and she is a regular contributor for Benzinga.