The Right Way to Handle an Inheritance
By Kira Brecht
If you are fortunate enough to receive an inheritance, buy a nice bottle of Champagne and toast your benefactor. But then institute a cooling-off period before you start spending, financial advisors recommend.
A new car, vacation or kitchen renovation may be in your future, but make sure you carefully assess your financial picture and retirement planning goals so you can maximize the inheritance for your long-term financial security.
"Say, 'I'm not going to do anything for three months.' Develop your plan. Don't react emotionally," says Ann Minnium, a certified financial planner and founder of Concierge Financial Planning LLC, based in Scotch Plains, New Jersey.
Even if you are skilled at managing your money, experts say it's still important to take a breather and develop a financial plan. In the meantime, you could park the windfall in a high-yield savings account or a balanced mutual fund for six months or so to sort out your priorities.
"Don't go out and quit your job, give money to your family and friends or buy that new Bentley before you determine how wealthy you really are," says Marcus Miller, an advisor at Indianapolis-based Deerfield Financial Advisors.
Minnium says she worked with a married couple in their mid-30s who received an inheritance of about $80,000. "They mindlessly spent away about $5,000 because they got excited," she says. "See an advisor who can take a global look at your financial situation. Formulate a financial plan so you can see what the best use of those resources will be."
Here are the best ways to handle an inheritance, according to advisors.
Create a list of financial goals. Prioritize and address any bad financial habits that have tripped you up in the past. Also, do a cash-flow analysis to see how much money you need both in the short term and long term to help you determine where you should direct the money.
Fund an emergency account. A top priority should be your emergency cash reserves. Do you have at least three to six months of living expenses in an emergency fund you could tap at a moment's notice? Before directing the money elsewhere -- even toward debt reduction -- make sure your emergency account is fully funded.
Three months is the minimum you should have access to, says Danielle Schultz, a certified financial planner and principal at Haven Financial Solutions Inc., an Evanston, Illinois-based fee-only financial planning firm. "If you don't have an emergency fund, you will always have debt. When the next emergency happens, back it goes on the credit cards," Schultz says.
Pay down debt. The next priority is outstanding debt, which can include student loans, credit card debt and mortgage debt. The couple Minnium advised had student loan debt. "Their monthly payment was not even covering the interest. We directed $20,000 of the inheritance to that loan," Minnium says.
For other debt, including mortgages, it is important to consider the interest rate and compare that to an expected investment return. "If the debt is at a relative high rate, say over 5 percent, probably you should consider paying it off," Schultz says. "But if it is a low-rate mortgage, and you are relatively young with decent employment prospects, you'd probably be better off investing."
For example, look at the after-tax rate of interest you are paying on your mortgage. "If you are in the 25 percent tax bracket, paying 4 percent on your mortgage, you receive a tax deduction for part of the mortgage, which means you are really only paying a 3 percent interest rate," Miller says.
Compare that to a diversified portfolio of stocks and bonds that could earn 6 percent to 7 percent annually, he says.
Retirement savings. Next in line is investing in your retirement savings accounts. If you haven't been contributing the maximum to a 401(k) or individual retirement account, do it now. "Say you earn $65,000 this year and spent it all.
But now you receive an inheritance of $100,000. Contribute to your Roth or workplace retirement from the $100,000, sheltering some of it from taxes and allowing it to earn tax-free [returns]," Schultz says.
Miller agrees: "In almost all cases, it makes sense to maximize your retirement accounts if your cash flow allows you to do so."
Have a little fun. Finally, some advisors suggest spending 5 percent to 10 percent on discretionary purchases. "It is nice to treat yourself. List that as one of your goals, and then you can decide if it is really worth it or not," Minnium says.
Just don't use a one-time windfall as an excuse to change your lifestyle. Deploying that inheritance wisely can help you climb onto firmer financial footing and lay the groundwork for a more secure future