While being on the receiving end of a financial windfall should be a blessing, for too many inheritors, it’s often a curse. The unfortunate reality is that American families don’t have a great track record of preserving legacies for the good of their families and future generations. To put it simply, many families don’t know what to do with a $500K inheritance. Tragically, for one-third of families, their wealth decreases following an inheritance and, for nine out of ten families, their inherited assets evaporate entirely before reaching the third generation. 1, 2
For many, a family inheritance can be life-changing – a real opportunity to change their financial trajectory and take their lifestyle to the next level. In many cases, it also the hope of their parents that their bequest becomes a lasting legacy that could benefit future generations. To a great extent, the heirs of a large inheritance are stewards of a legacy that should be honored, grown, and preserved for the benefit of the next generation.
If you are (or will be) the beneficiary of an inheritance, it would be essential to think about the long-term impact of your decisions, regardless of its size. For illustrative purposes, we map out the steps a family should take to make the best decisions about what to do with a $500,000 or larger inheritance.
The first question that comes to inheritors’ minds is, “how should I invest a $500,000 inheritance?” While that is a critical question that we address here, it’s essential to first think through what you hope to accomplish with the inheritance. How can this money, which is the result of your parents’ or relatives’ generosity and love of family, help you achieve your life ambitions? What would your parents want to see happen for you and your family?
It’s critical to have a purpose for the money. Without a purpose, it’s easy to get lost in the pursuit of more, which doesn’t necessarily lead to lasting fulfillment. How can the money be used or invested to create the most economic value for your family and the next generation? Having a purpose and a vision and sharing it often with your family is the surest way to make the right decisions.
The time you take to think about the legacy’s purpose will help you avoid making any quick or rash decisions about what to do with your inheritance. While there may be some exceptions—i.e., paying off high-interest debt is always a good decision – it’s essential to take the time to plan. Put the money in a six-month bank CD for safe-keeping.
After paying off any high-interest debt, the next non-rash decision you make should be to create an emergency fund if you don’t already have one. An emergency fund is essential to cover any unexpected expenses arising from an emergency – a job loss or period of disability, a medical emergency, major car or home repair, or anything else that might require immediate cash. A general rule of thumb is to have set aside six to twelve months of living expenses. Your emergency fund should be invested in a liquid savings vehicle, such as a savings or money market account.
If you think having more money will make your life easier, think again. A sudden windfall can make life much more complicated. Suddenly there are tax, estate, investment, and financial planning issues to address – areas that require a high level of competence to understand and manage. It’s vitally important to find experienced advisors who will put your best interests first.
A Certified Financial Planner (CFP) is best positioned to work with you holistically to address all your planning needs. CFPs have expertise in multiple financial disciplines and are used to working collaboratively with a team of advisors that might include a tax professional, attorney, and investment advisor. Before turning your money over to any investment advisor, make sure he is a fiduciary who is required by law to put your best interests first. Most importantly, a good advisor who understands you and what you want to accomplish will help you avoid emotionally driven mistakes that could cost you a good portion of your inheritance.
For an inheritance of $500,000 or larger, there are no off-the-shelf solutions that could address an individual investor’s unique needs, objectives, and investment profile. Before investing any money, it would be essential to have a personalized investment plan that considers your specific investment objectives, tolerance for risk, and investment time frame. Studies show that investors with a well-conceived long-term investment plan generate returns better than those who don’t have a plan.
Here are the key elements of a sound, long-term investment plan:
Having a purpose for your money is important because it gives you the conviction to focus on doing the right things with your money. However, you still need clearly defined goals and investment objectives to guide your investment decisions. Setting goals is about translating your life ambitions into quantifiable and achievable financial targets.
Studies show that as much as 93 percent of a portfolio’s return is not determined by individual investments, but rather by the mix of assets inside the portfolio. So, the mix or allocation of assets is far more important than the selection of investments.
The key is determining which asset mix would produce the kind of returns you need to achieve your objectives within the constraints of your risk tolerance. Asset allocation is not concerned with choosing individual securities. Instead, it’s about selecting the right mix of assets with a weighting that conforms to your investment objectives and risk profile.
A younger person with a longer time horizon might have a higher risk tolerance than someone closer to retirement. The younger person might allocate more money to riskier assets that can generate higher returns. The older person might reduce his exposure to riskier assets to preserve capital for retirement. Your asset allocation may change over time as you get closer to retirement.
When investing, it’s virtually impossible to know at any given time when one asset class or asset subset will outperform another type of asset. The solution is to diversify your portfolio among various types of assets to capture returns whenever and wherever they occur. Diversification reduces your risk exposure to any single asset that might drastically underperform. You can think of diversification as a method to control risk and volatility in your portfolio.
The key is to choose assets with a low correlation with each other. For instance, when stocks are performing well, bonds tend to perform poorly – and vice-versa. Within a stock portfolio, blue-chip stocks provide stability and dividend income, while small-cap stocks offer high-growth potential. Each of these assets can contribute positively to an investment portfolio,
If you are new to investing, your challenge is choosing from a vast universe of possible investments. Between individual securities, mutual funds, and exchange-traded funds (ETFs), you have thousands and thousands of investment choices.
With $500,000 to invest, your best options for developing the right asset allocation while achieving optimal diversification are index funds and exchange-traded funds (ETFs). For many people new to investing, index funds and ETFs are popular because they offer instant diversification and professional management. You can choose from among different asset classes to create an asset allocation that conforms to your risk-return profile.
These funds invest in the different stock indexes, such as the S&P 500 or the Russell 2000 index, as well as different market segments, such as real estate, discretionary stocks, and energy stocks. Most have low management fees, which is essential to ensure you keep most of your money working for you.
While you won’t pay any taxes on your inheritance, you will pay more in taxes depending on your investment activities. The key to maximizing wealth over time is to minimize the taxes you pay on your investments. Generally, you only pay taxes on your investments when they are sold for a gain. If you hold your investments longer than a year, you’ll pay a more favorable capital gains tax than if you sold them within a year of buying them. If you hold your investments until you die, your heirs will receive a stepped-up basis on the securities they inherit, virtually eliminating any tax you might have paid.
Investors who minimize their trading activities can reduce taxes on their investments. Also, a good financial advisor will know how to harvest your portfolio for tax losses. If, during the year, any of your investments perform poorly, they can be sold for a loss, which can be used to offset any capital gains or deducted from your income (up to $3,000 each year). Those securities can then be repurchased after a period of time, hopefully at a better price.
For many inheritors, a sudden windfall may bring out their philanthropic desires. If that is your desire and you are new to philanthropy, contributing to a donor-advised fund is a smart, flexible, and more cost-effective way to give more thoughtfully and strategically. You can establish a donor-advised fund for as little as $5,000 with the help of your financial advisor. The fund becomes a repository for all your charitable contributions until you decide when and to whom you want to make a gift. Or, you can leave your contributions to accumulate in an investment account. You are eligible for a tax deduction in the year you make the contribution, even if gifts aren’t made. Your fund custodian will do all your tax reporting. If you gift appreciated assets, which is a smart approach, your beneficiaries will realize no capital gains.
If you intend to pass the legacy on to your children, you will need to develop an estate plan that minimizes estate taxes while facilitating the transfer of assets. If your wealth grows to more than the estate tax exemption ($11.7 million in 2021, $23.4 million per couple), your estate could owe taxes at a rate of 40% on the excess. If your total estate is smaller than the exemption, it would owe zero taxes. However, if you live in one of the 17 states that levy an estate tax or an inheritance tax on beneficiaries, the exemptions are much lower or nonexistent.
Working with an estate attorney, you will need to consider the most effective methods for transferring your assets with consideration for taxes and any particular circumstances. You may need a trust arrangement to maximize your estate for your spouse and other arrangements for distributing assets to minor children. At the very least, you will need a living trust with a designated executor, a pour-over will, a power of attorney, and a medical directive to ensure your assets are distributed as intended.
Figuring out what to do with an inheritance is no to time be a do-it-yourselfer. As you can see here, there are many complex, moving parts involving several financial disciplines. This is a critical time to work closely with a trusted advisor who can quarterback your financial team to ensure your inheritance remains a blessing and doesn’t become a burden.