For many people, receiving a large inheritance can be a life-changing event. Unfortunately, it’s not always for the better. In general, American families have been notoriously inept or neglectful at preserving legacies for their benefit and the benefit of future generations. Remarkably, one-third of heirs manage to decrease their wealth following an inheritance, and an astonishing 90 percent of families find a way to squander it entirely after it passes to the second generation.
This country’s poor track record on inherited wealth may be the consequence of heirs who are ill-prepared to handle the responsibilities of new-found wealth and do not understand their roles as stewards of a family legacy. It may also be due to a lack of vision and purpose for their own family legacies. When people have money with no purpose for it, it tends to lead to the “pursuit of more,” with little hope for lasting fulfillment. Often, it is the result of bad decisions and poor money management.
Though the odds seemingly foretell it, inheriting a large amount of money doesn’t have to be a curse. Placed in the proper perspective and managed with intent and purpose, a large inheritance can change the financial trajectory of your family’s lives and the lives of future generations. This guide provides the framework of a plan that can honor, preserve, and grow a family legacy.
There is no reason to make any snap decisions about how to proceed with a large inheritance. Let it sit in a risk-free, interest-bearing account until you get your bearings and think through the critical next steps as outlined here.
The wealth you inherit was created by someone else, perhaps your parents, who wanted to see it live on as a legacy. They likely had a vision or purpose that is as much a part of the legacy as the money itself. If that wasn’t communicated to you, take some time to think about what they would have wanted. What would they have wanted to happen for you and your family? What were their values and attitudes about money they hoped to instill in you?
You can honor the legacy by having a purpose for it. Maybe it’s a family mission—a creed for your family to follow as you all pursue your life ambitions that will lead to greater shared economic value for them and future generations. Having a vision and a purpose for your money with the entire family on board can provide the guiding compass you need to make the right decisions.
Managing a large amount of money can be complex. Receiving a sudden windfall magnifies all the issues and the consequences of your decisions. You have tax implications to consider, and now you have your own estate planning issues. Critical investment decisions have to be made along with many other financial planning issues that must be addressed to optimize the value of your inheritance for you and your family.
Nothing short of competent and trusted advice from a team of financial professionals will suffice for protecting and growing your legacy. It’s best to start with a Certified Financial Planner (CFP) who is best positioned to quarterback your team. They have competence in multiple financial disciplines and are well-positioned to lead a collaborative team of advisors, such as attorneys, tax professionals, and investment advisors. Wait until your team is in place before making any critical decisions.
When you didn’t have much money, it was necessary to prioritize things to ensure you spent your money wisely. It’s no different when you have a lot of money, except that the stakes are higher. While you may feel like you can accomplish many things with more money, it’s even easier for things to spiral out of control if you don’t have priorities and restrictions to guide you.
Here are some financial issues that you can address immediately that will improve your financial position:
Your next financial move should be to create an emergency fund. An emergency fund consists of cash (in a savings or money market fund) that you set aside strictly for emergencies, including a major medical emergency or home repair or a job loss or disability that could prevent you from generating an income. It should be sufficient to cover three to 12 months or more of living expenses.
Paying off debt your high-interest debt and any student loans. If you have the cash and doing so won’t impede your current living needs or your ability to fund your most important goals, there’s no reason to maintain any debt. You should talk with an advisor before making any big decisions.
A mortgage is debt, but it is good debt. Whether you should pay it off with inheritance money depends on the loan amount in relation to the size of your inheritance. If paying off your mortgage could impede your investment plan or other critical goals, you should work with your financial planner on the best strategy.
One of your top priorities should be to secure your retirement by allocating sufficient assets to generate an income you cannot outlive. It’s essential to create a separate allocation of assets for your retirement to know it’s secure and you feel confident using other funds for different goals and priorities.
Another move to consider is to lock in your children’s college education funding. The younger they are, the less you need to commit to their college fund. Work with your financial planner to calculate how much to invest now to cover future costs. Your best funding option is a 529 college savings plan that allows earnings on your contributions to grow tax-deferred, and if the funds are used for eligible college expenses, your withdrawals are tax-free. There’s no limit to annual contributions, but you will want to coordinate them with your annual gift tax exclusion, which is $16,000 per person in 2022. If both spouses use their annual exclusion, that will allow for $32,000 in yearly contributions per child.
For many people, receiving a large inheritance can trigger their altruistic tendencies. If your parents contributed to charities, it’s an opportunity to use a portion of the estate to continue their legacy. If you want to start your own philanthropy, you could begin by establishing a donor-advised fund (DAF) for as little as $5,000. The advantage of a DAF is you can establish it through your financial advisor today, contribute however much you want, and make decisions later about who you want to benefit. You benefit from a current tax deduction on your contribution even though it may not be paid out until later.
Investing a large sum of money opens the doors to more options and opportunities to grow and preserve your wealth. However, you should only proceed under the guidance of a trusted investment advisor who understands your unique circumstances, objectives, and risk profile. An investment advisor can work with you to create a personalized investment plan with an appropriate asset allocation strategy.
With a more considerable sum of money to invest, you can find the right asset mix and achieve optimum diversification for growing your assets while minimizing portfolio volatility. Here are some investment options you can consider with your investment advisor:
Stocks offer an opportunity to earn positive long-term returns. A portfolio of high-quality, well-managed companies that consistently grow their earnings is a good way to grow wealth while minimizing your risk. Investing experts say you should diversify your portfolio make sure it is properly balanced. For a minimum of $250,000 in assets, an investment advisor can identify, analyze, select, and manage a customized stock portfolio.
Exchange-traded funds (ETFs) are a low-cost way to participate in the growth of a stock index or specific sector of the economy. They are typically made up of dozens or hundreds of different stocks, providing you with instant diversification. They are traded like stocks on the stock exchange to be bought and sold quickly.
Mutual funds are another great way to be diversified with stocks and bonds. Most mutual funds are actively managed, meaning a portfolio is individually selecting the stocks and/or bonds it invests in providing the investor with the potential of higher returns than the market.
Real estate is another asset with proven wealth-building qualities. People of wealth can own investment properties that generate income and capital appreciation. They hire property managers to manage maintenance, tenant issues, and leasing out the property. Alternatively, you can invest in real estate investment trusts (REITs) if you want a more diversified portfolio of managed properties.
These are just a few investment options available to high-net-worth investors. Your investment advisor has access to many more that may be suitable for your particular circumstances, investment objectives, and risk profile. The key to a sound investment plan is finding the optimum mix of different assets to meet your return expectations while minimizing risk and volatility.
Although in most cases you won’t owe taxes on the money you inherit, you could increase your tax liability through your investment activities. The key to building and preserving wealth is to minimize the impact of taxes on your investment returns.
Generally, you owe taxes on money your investments generate, either through income received or gains on investments you sell. The exception is for income received from tax-exempt investments such as municipal bonds. You are taxed at either your ordinary income tax rate or the more favorable capital gains tax rate on all other investments.
Income from taxable bonds is taxed at your federal income tax rate, which can be as high as 37%. Income received from stocks, either through qualified dividend payments or gains on stocks held for more than one year, is taxed at the capital gains rate, which tops out at 20%, nearly half the top ordinary income tax rate.
A good investment advisor can develop an investment strategy that creates tax efficiencies, enhancing your investment returns. They try to minimize trading activities that result in taxes. They also know how to use portfolio losses strategically to create tax losses that can offset gains, thereby reducing your tax liability.
The good news is most investments you hold until your death are passed on to your heirs on a stepped-up basis, meaning you will have managed to avoid paying any taxes on those investments.
When a home is a part of an inheritance, you have much to consider. You essentially have three options: you can choose to sell it, rent it out, or live in it. Each option comes with particular issues that must be considered to evaluate if it’s the right option for you.
If you decide to sell the home, you can avoid the legal and financial responsibilities of renting or living in it. But it could require an investment of time and money to bring it into a saleable condition. That could involve both interior and exterior work, possibly having to bring the house up to code. In some cases, the cost of home upgrades or repairs doesn’t result in a proportionate increase in the home’s value. Alternatively, you can sell it as is.
If you also inherit a mortgage with the house, you will need to continue the mortgage payments until sold and then use the sale proceeds to pay it off.
If you want to keep the house as an investment, you could rent out the house. There are tremendous benefits to owning an investment property, including its tax treatment as a depreciable asset. Also, the passive income it generates is taxed more favorably than your ordinary income. And real estate values, in general, tend to always increase over time.
However, there are several factors to consider:
Alternatively, you could hire a property management company to take all that off your hands, but the added cost should be factored into your cost-benefit analysis.
If you have an emotional attachment to the home, you could choose to make it your own and live in it. It may require home improvements or upgrades, but at least you won’t be pressed into doing that right away.
You also have to consider additional costs such as property taxes, HOA fees, and maintenance. If the home comes with a mortgage attached, you need to decide whether to pay it off with inheritance funds or continue making mortgage payments.
It’s not uncommon for a home to be left to multiple family members, creating problems if they disagree on what to do with the property. One solution is to enter an arrangement where one family member buys out the others.
When you inherit a home, you receive it on a stepped-up basis, meaning you are not responsible for taxes on any gain in the home’s value over what it was worth the day you received it. For example, if your parents bought the house for $150,000 and its fair market value is $300,000 on the day you take the title, you are not responsible for taxes on the $150,000 gain.
If you decide to live in the home, you will qualify for a capital gains exclusion on the sale of the property if you live in it for at least two years (as long as you haven’t used the exclusion on another property). Individuals can exclude $250,000, while joint filers can exclude $500,000. So, if a home you inherited for $300,000 is eventually sold for $500,000, your exclusion would allow you to avoid any capital gains taxes.
Deciding what to do with an inherited home is no small matter. Your first course of action is to work with your financial advisor to analyze the costs and benefits of your options.
Most people who bequeath a large sum of money want to know that it will benefit future generations. The first generation of inheritors are stewards of the legacy until it is passed on to the next generation. Your success depends on the decisions you make during your lifetime and how well prepared the next generation is to receive it.
You should work with an estate attorney at the earliest opportunity to construct a plan designed to maximize the distribution of your estate to your heirs. In addition, it would be essential to communicate your intent and desires for your legacy along with the values and attitudes about money you want to instill in your children.
Your first step is to align yourself with a trusted financial advisor who can help you navigate the complexities of inherited money to ensure you can fulfill your life ambitions and those of your family and their families.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Dechtman Wealth Management, LLC [“DWM”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from DWM. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. DWM is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the DWM’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at www.dechtmanwealth.com.
Please Note: DWM does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to DWM’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
Please Remember: If you are a DWM client, please contact DWM, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently.
Please Also Remember to advise us if you have not been receiving account statements (at least quarterly) from the account custodian.