This article was updated on December 29, 2021 to reflect current tax laws and limits.
A large sum of money falls into your lap. What do you do?
Since inheritances don't happen everyday, it's not uncommon for recipients to feel confused as to their next steps. Due to the unfamiliarity of the situation, and the events involved, it's easy for even the most rational person to make some costly financial mistakes. But you don't have to.
In this article, we'll review the most common inheritance missteps we've seen during our 20 years of experience as financial advisors. Though we recommend getting personalized guidance from a professional, making yourself aware of these mistakes ahead of time can be helpful:
1. Not Taking a Deep Breath
Unexpectedly receiving a large sum of cash can be overwhelming, no matter who you are. For heirs of modest means, having that much money can even feel a little scary. Of course, different people handle those feelings in different ways.
Obviously, inheritances are often received when a loved one dies. And the grieving process associated with that event can last for an extended period of time. Between having new found wealth and grieving, life can feel a little stressful until things transition to a new normal. Take your time and take care of yourself so you are able to make important decisions when it is time.
Some may be tempted to immediately make large purchases on lavish cars, houses and gadgets. And yet others may feel like setting aside the money all together due to emotional attachment. Whatever the case, take a deep breath and relax before taking action. Yes, you will have to make some important decisions, but they needn't be rushed.
2. Failing to Assess Your Financial Situation
Whatever your situation, it's important to step back and ask yourself: How much financial planning have I done for the future? And how can this money best serve my goals? Whomever left you that money undoubtedly wanted you to be comfortable in the years to come.
And that means taking stock of your assets, debts and future needs (i.e. retiring comfortably, sending kids to college). Additionally, if you don’t currently have an emergency fund equal to at least six months of expenses, use part of your inheritance to create one (this should be kept in safe and easy-to-access investments).
3. Letting Money 'Sit'
In the midst of analysis paralysis, many people allow their money to just sit in the bank. Unfortunately, this means their cash is earning next to nothing, as they are simultaneously not enjoying its benefits. An inheritance is meant to enrich your life, not the bank's life!
The best way to begin "unfreezing," is to do your research. Get advice from knowledgeable people you can trust, ask lots of questions and then repeat. Pretty soon, you'll feel confident letting that cash work for you.
4. Not Paying Off Debt
Spending inherited money is not a bad thing. But, before you spend, pay off any lingering debts. Particularly those high-rate credit card debts and car loans. High-interest debts are the worst because you don’t make much progress with minimum payments! We know It may sound boring, but paying off debts now will free you up for a better future where you can make decisions from a less-burdened place.
Additionally, if you know your mortgage will be a burden in retirement, consider paying it off. If you have a low interest mortgage, consider working with an advisor or CPA to determine if it is in your best interest to keep it. Just be sure to evaluate your tax angles, since mortgage interest is deductible for taxpayers who itemize.
5. Not Making An Estate Attorney Part of Your Team
Inheritances don’t always arrive in cash or stocks. Sometimes they come in the form of real estate, businesses, farms or family trusts. Having an estate attorney navigate the legal ramifications and financial options is more than worth their fees.
It's important to note that estate taxes can also wreak havoc on your own estate (the maximum tax rate is a whopping 40 percent). Thus, inheriting a large sum and combining it with your own will create future problems if not properly addressed. The federal estate tax exemption for 2022 is $12,060,000 per individual and twice that for married couples. Adding up previous assets, retirement accounts, homes, life insurance and a new inheritance can make estate taxes a liability.
6. Not Understanding IRAs or Tax Implications
One of the most common forms of assets handed down are retirement accounts. Retirement accounts have their own rules, and many require assets are withdrawn over a certain time-period. Understanding your options and how they impact your taxes is important. For example, liquidating an entire retirement account for cash, could put you into a higher tax bracket. Come tax time you might be kicking yourself when you get that huge bill.
In some cases, you may be advised to renounce part of your inheritance. For example, say you receive a timeshare you don't intend to use. It may have annual maintenance fees and property taxes attached. The bottom line: Talk to a professional, understand your options and keep your taxes low.
7. Giving Too Much Money Away
No matter how much you inherit, it will not last forever. It's reported that Mike Tyson earned over $400M during his career, yet was broke by the age of 39. While we're not sure exactly what Mike did to blow all that cash, we do know many people prematurely give too much away.
Sharing with others isn't necessarily a mistake. Giving to a charity a late relative cared about may be part of preserving the person's legacy, for instance. But giving away large sums of money out of guilt, because you feel undeserving or because other friends or relatives pressure you for handouts, is never a good idea if it means jeopardizing your own future financial security. Giving should come from a planned approach that reflects core values, rather than be driven by ad hoc guilt or third-party pressure
8. Holding Onto Legacy Investments
If you've been fortunate enough to inherit an investment, you understand the mixed feelings it entails. But the question of how to handle those inherited investments can often cause confusion. If Dad said to "never sell that company," should you continue to honor that request in the face of alternative evidence?
Although that investment may have been a large source of family wealth in the past, it could just as easily become a burden in the future. Put simply, if the investment doesn't fit into future investment plans, it needs to go.
9. Not Getting Expert Advice
Even if you're not the type of person to buy a boat or fly to Vegas on a whim, you could benefit from the advice of a qualified accountant and attorney when handling an inheritance. Once word gets out, don't be surprised if you begin receiving solicitations from people offering "investment opportunities." Many of these may not be in your best interest.
Which is why partnering with a financial advisor to review your options is key. Having a professional to talk with will lessen the stress and help you avoid the common mistakes others routinely make. After all, your inheritance should be a joy, not a burden.