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Investing your inheritance: A guide to help you grow a recent financial windfall

Investing an inheritance
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Inheritances aren’t all that common — only about 20 percent of households receive them. Although far from the majority, it still impacts the finances of millions of people. In fact, tens of trillions of dollars will be passed along through inheritances in the next 30 years, according to a 2019 report from wealth manager United Income.

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 to 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 equities, 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. This could be any type of invested asset, including stocks, bonds, IRAs, etc. 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.

Perhaps you are an experienced investor who wouldn’t mind having a whole investment portfolio dropped in your lap — or maybe not. 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.

One thing to keep in mind with inherited investments is the potential tax implications. First, the good news: you are not liable for taxes on inherited stocks yourself as the tax liability falls to the estate. They also have a stepped-up tax basis, meaning you only pay taxes on what the original owner paid for the shares. However, if you sell shares, you are then liable for taxes.

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. 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 in front of you 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 that is passed on to the next generation. Deciding what to do with that home isn’t always an easy decision, especially since emotions may run high. After all, the home may have significant sentimental value. Nevertheless, inheriting a home can come with its own set of benefits and challenges.

Your three basic options are to sell the home, rent it, or live in it. Again, each one of these options has pros and cons; let’s take a brief look at each of them.

Sell: 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 only pay taxes 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: Renting the home you inherit isn’t much different from 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 your childhood home unless you pay someone to manage it for you. Taxes can be complicated, too.

Live there: Deciding to stay in your 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; living in your inherited home can be a way over this hurdle. However, don’t forget about property taxes and the seemingly constant upkeep that can sometimes come 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. To answer that question, you must answer some basic questions, namely:

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

Risk tolerance is important to determine because it is critical to “stay the course,” as the saying goes. 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 will need the money is important for a couple of reasons. First, it may determine where you hold the money; for example, money held 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 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 will 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, 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. There are many examples of high-risk investments, but some include investing in initial public offerings (IPOs), high-yield bonds, individual stocks, cryptocurrency and more. Even a portfolio consisting of 100 percent mutual funds is considered relatively high-risk.

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, withdrawals or contributions may come with valuable tax breaks.

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

  • IRA: Contributions may be tax-deductible; growth not taxed. Withdrawals taxed as ordinary income.
  • Roth IRA: Contributions are taxed as ordinary income; capital gains not taxed. Qualified withdrawals are not taxed.
  • 401(k): Contributions are tax-deductible; growth not taxed. Withdrawals taxed as ordinary income.

As you can see, the biggest difference between a Roth and a non-Roth account is when the money is taxed. For traditional accounts, withdrawals are taxed as income; for Roth accounts, contributions are. However, all of these accounts have tax-free growth, which is their biggest advantage. After all, you can leave money in them 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 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, there is one thing that is impossible to predict: marginal tax brackets. If marginal tax rates are higher in the future than they are today, once again, 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 as losing a parent or other loved one. Thus, it can be equally challenging to know the right way to handle your inheritance.

The good news is that most, or at least many, of the things you may inherit are common assets to which mainstay personal finance principles apply. In other words, using your inheritance to pay off debt, build an emergency fund and invest are likely your best courses of action.

Things can get slightly more complicated if you inherit your childhood home, but ultimately a house is still a house. You can sell it, rent it, or decide to live in it. Each choice comes with its own benefits and drawbacks.

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.

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