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How to invest an inheritance

Investing an inheritance
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Inheritances aren’t all that common — only about 20 percent of U.S. households receive them, but that’s still millions of people who need to decide how to handle them. In fact, tens of trillions of dollars will be passed along through inheritances in the next 30 years, according to a study from wealth manager United Income, which was purchased by Capital One in 2019.

Here’s how you can make the best use of an inheritance by investing it.

How to get started investing an inheritance

So, what is an inheritance? An inheritance is simply the passing of assets from one person to another after someone dies. Those assets may include property such as a house, cash, investments, jewelry, and other valuable items. Inheritances are passed along to either a beneficiary (someone named in a will) or an heir, which may be a child or surviving spouse.

Prioritizing how the inheritance is used is essential. If you have high-interest debt such as credit cards or personal loans, it makes sense to pay those off first. The same applies if you have little or no emergency fund, which should cover about six months of expenses.

After taking care of these bare necessities, you should consider investing the remainder of your inheritance. By doing so, you can build wealth that may not have been achievable otherwise. If you choose to invest a sizable sum of money due to your inheritance, ensure your investments are diverse.

That means investing your money in a variety of stocks, bonds and funds. You might also consider investing in additional asset classes, such as real estate, gold, cryptocurrencies or other alternative investments. While many investors have the bulk of their investments in domestic stocks, adding some other investments to the mix can act as a valuable hedge.

What to do with inherited investments

Inherited investments are any investment assets passed on to a beneficiary or heir. Thus, you could be inheriting individual stocks and bonds or an investment portfolio containing some combination of individual stocks and bonds or perhaps mutual funds and ETFs. Some companies have equity-sharing programs where they issue shares of their own stock to employees as a retirement benefit. This may also be an inherited investment.

It can be overwhelming receiving all of these investments, particularly if you are not an experienced investor. Thus, hiring a financial advisor may be a good idea, at least until you can sort through the investments.

One step of this process might be restructuring the investments to match a strategy that fits your goals. The good news is that once that process is done, you may be able to automate the portfolio entirely.

An important thing to keep in mind with inherited investments are the potential tax implications. First, the good news: you are not liable for taxes on inherited stocks, since the tax liability falls to the estate. Any investments that you receive have a stepped-up tax basis, meaning the cost basis changes to the price at the time of the inheritance, allowing you to avoid capital gains taxes on the appreciation during the life of the previous owner. However, if you sell shares, you are then liable for taxes on any subsequent gains.

Another important point is required minimum distributions (RMDs) if you inherit an IRA from anyone other than your spouse. In such a case, you must draw down the entire value of the IRA over time. And if the IRA is a traditional IRA and not a Roth, those RMDs will be taxed as income. Thus, you could end up with a large tax liability if you inherit a traditional IRA with a high balance.

What to do with inherited real estate

Another common inherited asset is property, such as a home. Inheriting a home can come with its own set of benefits and challenges. Deciding what to do with that home isn’t always an easy decision, especially since emotions may run high and the home may have significant sentimental value.

Your three basic options are to sell the home, rent it, or live in it. Each of these options has pros and cons.

Sell the home 

Selling the home has the obvious benefit of providing an influx of cash upfront. You can use that cash for any of the purposes mentioned earlier, such as paying off debt or investing it. You can even use the cash to invest in other real estate properties.

In addition, inherited homes have a stepped-up tax basis, meaning you don’t pay taxes on the entire value of the home. Instead, you pay taxes only if the home sells for more than it is worth at the time of inheritance. So if it was worth $200,000 when you inherited it and you sold it for $250,000, you only pay taxes on $50,000 of it.

Rent the home 

Renting out an inherited home isn’t much different from renting any other rental home. The biggest difference is probably the emotion that may still be tied to the home. Still, rental homes can provide cash flow, which is an attractive option. Plus, this cash flow creates more diversification as you work to build wealth.

However, remember that the house will need maintenance, which would mean visits back to the property, unless you pay someone to manage it for you. Taxes can be complicated, too.

Live in the home

Deciding to stay in the inherited home can be a good option if homeownership is something you’ve desired but perhaps did not have the financial means to reach. Many banks require a sizable down payment before issuing a mortgage, so living in an inherited home can be a way to overcome this hurdle. However, don’t forget about property taxes and the seemingly constant upkeep that often comes with owning a home.

Ready to invest your inheritance money? Consider stocks, bonds and funds

While in theory it is possible to hold cash or have your inheritance windfall sit in a money market account, that would not be an ideal strategy.

To realize the biggest benefit from your windfall, you should take a look at investing in stocks, bonds and funds.

If you don’t have a lot of experience with investing, you may not know where to start, but answer some basic questions first:

  • What is your risk tolerance?
  • When will you need the money?

Risk tolerance is how much risk you’re willing to deal with in order to earn a return. The best investments require at least some risk tolerance. If seeing your portfolio lose 10 or 20 percent of its value would cause you a great deal of stress, then lower-risk investments are probably a better idea.

When you need the money is important for a couple of reasons. First, it may determine where you hold the money. For example, money in a retirement account generally cannot be withdrawn before age 59 1/2 without facing a 10 percent penalty, with a few exceptions. Thus, if you are contributing to a retirement account, it should generally be done with money you will not need before that age.

But there is another aspect to your time horizon: High-risk investments are usually not a good idea if you need the money in less than five years. This is because, depending on your timing, the investments could fall in value and take years to recover. They may well end up going much higher than they were before dropping, but if your time horizon is short, you may not have enough time to wait for them to rise again.

Such is the nature of low-risk vs. high-risk investments. Here is a quick breakdown of the two:

  • Low-risk investments: These investments are usually more stable and can provide modest short-term growth. Their long-term growth potential is lower, but that isn’t a concern if you will need your money in less than five years. Low-risk investments include Treasury notes, high-quality corporate bonds, and money market funds.
  • High-risk investments: These investments can be more volatile and thus need more time to grow. Although they have a higher level of risk, they can grow more in the long term. Some popular high-risk investments include initial public offerings (IPOs), high-yield bonds, individual stocks, cryptocurrency and more.

How to use tax-advantaged accounts to minimize taxes

When investing an inheritance, it is wise to take advantage of tax-advantaged accounts whenever possible. These include retirement accounts such as an individual retirement account (IRA), Roth IRA, 401(k), 403(b), and so on. Depending on the type of account, either withdrawals or contributions may come with valuable tax breaks.

Here is a brief rundown of the benefits of tax-advantaged retirement accounts:

  • Traditional IRA: Contributions may be tax-deductible, and taxes on any growth are deferred until withdrawn. Withdrawals are taxed as ordinary income.
  • Roth IRA: Contributions are taxed as ordinary income, and any gains are tax-free if they’re withdrawn in retirement.
  • Traditional 401(k): Contributions are tax-deductible, and taxes on any growth are deferred until withdrawn. Withdrawals are taxed as ordinary income.
  • Roth 401(k): Employee contributions are made with after-tax dollars, so qualified withdrawals in retirement will be tax-free. The account can grow tax-free.

The biggest difference between a Roth and a traditional account is when the money is taxed. For traditional accounts, withdrawals are taxed as income. For Roth accounts, contributions are taxed as income. You can leave money in these accounts, potentially for decades, continuing to grow the accounts without being subject to a penny in taxes.

Whether it is better to put money in a Roth or a traditional account is an ongoing debate, but it also depends on your circumstances. Therefore, it is impossible to say that one is “better” than the other. In general, if your income in retirement will be higher than it is currently, a Roth account might be better.

However, one thing is impossible to predict: marginal tax brackets. If marginal tax rates are higher in the future than they are today, a Roth wins. That’s because with a Roth, you pay taxes today, but none in the future. Of course, if taxes fall in the future, a traditional retirement account is better. Since we can’t know what marginal tax rates will be in the future, the only thing we can try to predict is what our income will be in retirement.

Bottom line

Receiving an inheritance can be challenging in a number of ways. You might receive a large sum of cash, investments, property, and other valuables all at the same time. Thus, it can be hard to know the right way to handle your inheritance.

Although the things you inherit are largely no different from any other financial asset, it can be an overwhelming experience for some. Don’t be afraid to work with a financial advisor if you feel you need the help. An inheritance can be a big boost to your finances, but only if it is managed properly. Using your inheritance to pay off debt, build an emergency fund and invest are likely your best courses of action.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

Written by
Bob Haegele
Contributor
Bob Haegele is a contributing writer for Bankrate. Bob writes about topics related to investing and retirement.
Edited by
Senior investing and wealth management reporter