education | protecting your wealth
Inheriting Money: Dos and Don'ts When Receiving a Lump Sum
By Kent Thune, CFP®
Receiving inheritance money can be an incredibly positive and life-changing experience. But it can also bring about new issues and obstacles if not approached properly.
There are some obvious benefits — and potential pitfalls — associated with receiving a large amount of money. Before deciding what to do with your financial windfall, it's important to educate yourself on personal finance guidelines around receiving lump sums of money.
3 Things to Do When You Receive an Inheritance
There are a number of advantageous strategies to weigh when looking to capitalize on the liquid funds, so ample consideration is needed.
As you work on a plan for your inheritance money, here are three advisable steps:
1. Deposit the mony into a safe account
Your first action to take when receiving a lump sum is to deposit the money into an FDIC-insured bank account. This will allow for safekeeping while you consider how to make the best use of your inheritance. The maximum coverage for each FDIC-insured account is $250,000. If you inherit more than this, you may want to consider a few strategies for bolstering your coverage.
2. Make a list of priorities
What do you want to accomplish with your money? Do you have high-interest debt to pay off? Are you on track for retirement? Is your home in need of improvements? Do you want to honor a legacy of the person who passed the inheritance to you? Give your money a purpose by aligning it with your most important financial goals and personal values.
3. Consult a professional
Depending upon the size of your inheritance, you may need to get the help of a professional (or team of professionals) to provide financial planning recommendations. A financial advisor can help to create and implement the best course of action on your priorities. Additionally, they can provide guidance in areas such as tax planning, investment advice or estate planning.
3 Things to Avoid Doing When Receiving a Lump Sum
As you can probably imagine, it's easy to make rash decisions when receiving a lump sum of money. As with all matters in personal finance, avoiding the wrong decisions can be as beneficial as making the right decisions.
Here are the three main actions to avoid taking immediately upon receiving inheritance money:
1. Don't quit your job immediately
Depending upon several factors, such as your life expectancy, your lifestyle and how you invest, it can take millions of dollars to safely secure the income you need for the rest of your life.
2. Don't spend before you plan
It can be tempting to go buy that luxury car you've always wanted or take the family on a lavish vacation. Splurging a little can be fine — but it's wiser to incorporate your spending into a broader financial plan.
3. Don't withdraw large sums from inherited IRAs
Although you may be able to avoid the IRS-imposed 10% early withdrawal penalty on an inherited IRA, you may still owe income tax when you withdraw money from it. And if the withdrawal is large enough, it may put you into a higher tax bracket.
Tips for Preserving Your Windfall and Building More Wealth
Once you are aware of the general dos and don'ts of receiving inheritance money, it's time to get more specific with the best practices to follow for financial windfalls. Here are several tips for making the best use of your inheritance:
Build an emergency fund. To prevent using debt for emergencies, try to set aside some money for such situations. Personal finance guru Dave Ramsey suggests putting aside three to six months of living expenses in a specifically designated deposit account. Online savings accounts often have higher interest rates than regular savings accounts, which makes them advantageous for individuals looking to make their money work harder — and help keep up with the rate of inflation — while setting aside money for surprise expenses.
Pay off high-interest debt. The average credit card interest rate is currently 17.89% for new offers and 14.52% for existing accounts. With rates this high, it can make sense to pay off this debt before investing. According to Experian, one of the three major credit bureaus, "If you have credit card debt at a 17% interest rate, you'd effectively be earning 17% in the form of interest savings when you eliminate that debt."
Fund your retirement accounts. A good financial plan can help you determine if you are on track for reaching your retirement savings goals. If not, you might be able to use some of your inheritance money to fund retirement accounts, such as an IRA. Keep in mind that you cannot directly make deposits to employer-sponsored plans, such as a 401(k), but you can increase your contribution amount through payroll.
Fund education savings. Financial industry experts often suggest funding retirement before your children's education savings. They can borrow for college; you can't borrow for retirement. If you have young children, education planning to fund college expenses can be a smart idea. Examples of accounts used for education savings include Section 529 plans and the Coverdell Education Savings Account (ESA). In some cases, a Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) brokerage account can make sense.
Consider creating a trust. If your inherited assets are above $100,000 or if you need to make specific plans for your wealth after you are gone, creating a trust may be a good idea. A trust can give you control over your assets, may provide tax advantages and may allow your heirs to bypass the probate process, which can be stressful and expensive.
Ultimately, receiving an inheritance can make your life easier — but it can also make your finances more complex. The most important financial decision you can make after receiving an inheritance is to put your money aside long enough to make smart plans for the financial windfall. The next best move is to hire an experienced professional or work with a financial institution that can help you make the right decisions for you and your family.