How to Invest an Inheritance | A 9-Step Guide


inheritance planning san diego

How to Invest an Inheritance – and More: A 9-Step Guide on What to Do With Inherited Money in San Diego

Imagine losing a parent or close relative and finding out that you just inherited $750,000. The money is overwhelming and the loss of a loved one is devastating.

Baby boomers today are an enormous cohort of nearly 80 million people and roughly 24 percent of the U.S population. These 55 to 73-year olds were born between 1946 and 1964. The average inheritance amount ranges from the low six figures to millions of dollars. You might think that despite the loss, it would be exciting to receive a large inheritance. For most, the entire experience is very overwhelming. Most don’t know where to begin.

Perhaps you’ve pondered how your life will change now that you’ve inherited money. You’ve probably thought about the real estate and travel opportunities that would arise. However, the reality is quite different. Processing an estate can take up to a year or more and shouldn’t be rushed. The time before you access your inheritance provides time to mourn the loss of your loved one.

Follow these nine steps to properly deal with a large inheritance.

1. Hire an Estate Planning Attorney

The large estate will need to be processed and an experienced estate planning attorney is an integral part of your financial team. You need to get this person right so talk with trusted friends and advisors before hiring the estate planning professional. Check references online and talk with others who have used this attorney to vet her or him thoroughly. Ask the estate planning attorney for a detailed explanation of the estate distribution process, timeline, and cost.

Please don’t rush this step. Getting this step wrong is more costly than the others.

2. Understand the Emotions Surrounding an Inheritance

emotional investorUnlike winning the lottery, an inheritance is accompanied by a loss. Typically, when you receive a big inheritance, that means that you lost someone close to you. It’s common to experience mixed emotions when losing a loved one. From the inability to resolve conflicts, to having things unsaid, it’s difficult to predict the emotions during the grieving process. You might be forced to deal with family members who aren’t of the same mindset as you. So, even if you’ve prepared for the loss, it inevitably comes as a surprise, with unpredictable emotions.

On occasion, guilt follows a large inheritance. Some feel unworthy or undeserving of the money. Others feel guilt over how they treated their loved one.

The reality is that the pain of loss can cloud your judgment. The last thing you want to happen is to make an erroneous decision while under emotional duress.

While experiencing these powerful emotions, you’re in the position of dealing with a large sum of money. This means that you might not be in the best frame of mind to make financial decisions. The confluence of loss with an inheritance requires that you refrain from acting. After a loss, it’s wise to take a time out and refrain from doing anything with the new money and possessions that you acquired. Give yourself permission to grieve and set a roadmap for handling the situation.

3. Identify Your Inheritance Investments

If you inherited $750,000 in all cash, then there’s not much to understand. You have the cash in a bank or investment brokerage account.

Read: The Best Financial Advisors in San Diego

For collectibles, hire an appraiser to value the items. Then, you and your family members can decide how to proceed. Decide whether to sell the objects or how to divvy them up among the beneficiaries.

If you inherit stocks, bonds, real estate, valuable collectibles and more, you need to understand what you own. Investments are a different story.

From stocks, bonds, mutual funds and ETFs to less frequently traded private equity and other investments, you need to assess the financial assets. It’s likely that you’ll want to sell some of the assets and reinvest them in a way that makes sense for you.

This stage calls for adding another member to your team, a financial advisor. Consider hiring a fiduciary financial advisor who is transparent and trustworthy. Again, speak with friends and research the professional on the FINRA BrokerCheck site.

A trusted financial advisor will help you work through the emotional aspects of investing as well. Just because your Dad worked for Qualcomm (Nasdaq: QCOMM) and had 25% of his investable assets invested in the company, does not mean you should hold on to those shares. A financial advisor can help separate emotion from the investment process and help you make sound investment decisions.

If you prefer to do-it-yourself, then educate yourself by reading several investment classics such as A Random Walk Down Wall Street by Bernard Malkiel, the Elements of Investing (only 100 pages) by Malkiel and Ellis, and Unshakeable by Tony Robbins.

4. Pay off Debt With Your Inheritance

If you have debt, consider using your inheritance to pay it off. A diversified investment portfolio might earn an annual return of seven to eight percent, depending on how it is invested.

If you have debt with interest charges higher than that amount, then you’re losing money by keeping the debt. For instance, credit card debt with interest charges of 16% and investment returns of 8% means that you’re losing 8% by not paying off the debt.

“Should I pay off my mortgage with my inheritance?” is a frequent question. While paying off high-interest credit card debt is a no-brainer, paying off your mortgage with an inheritance requires an analysis.

Consider the emotional and financial issues when examining whether to pay off your mortgage with an inheritance. If it gives you peace of mind to pay down your mortgage, then you have the answer.

The financial question is more complicated as your future cash flows will likely change over time. Financially, you can deduct mortgage interest up to $375,000, or $750,000 if you use the married filing separate tax status, to reduce your total tax bill. If your mortgage interest rate is less than five percent, it’s likely that you can earn more by keeping your money invested in the financial markets. You may also be able to deduct real estate taxes, adding another advantage to support holding on to a mortgage.

A compromise is to add money to the principal mortgage payment each month and reduce the mortgage term.

5. How to Handle Real Estate in Your Inheritance

Inheriting real estate is a mixed blessing. Rental property diversifies an all stock and bond portfolio, provides cash flow and other tax benefits. But, rental property can be a management nightmare. It is highly illiquid and there are numerous factors driving its profitability (or negative cash flow). With rental property, you, your family members, and a financial advisor can decide whether to keep the rental real estate or sell it.

While inheriting a family home requires a different decision-making process. Don’t underestimate the emotional attachment you and your siblings might have towards the house. With a family home, you face the choices of living in the home, selling it as is, renovating and selling it, or renting it out.

If renting the home out, review the discussion about rental property.

This is another opportunity where a financial advisor can help remove emotion from the process. Consider inviting in all the beneficiaries to discuss this hot-button topic. How to handle an inherited home might be one of the first decisions to tackle, as real estate has high maintenance charges including repairs and real estate tax payments.

6. How to Invest a Large Inheritance

Before deciding how to invest the assets, it’s essential to map out your life and financial goals. The perfect investment approach is different for everyone. Yet there are general investment principals that will grow your inheritance for the long-term.

Whether enlisting a financial advisor or doing it yourself, use well-researched investment principles to create a smart and lasting investment strategy.

First, set cash aside for a robust emergency account equal to three to six months of living expenses (or more). If you’re retired, increase the cash amount to equal up to three years of living expenses. This way, when unforeseen expenses emerge, you won’t be forced to sell investments at an inopportune time. Invest this cash in a high-yielding savings account, such as Ally Bank. The returns on these funds change along with current changes in interest rates and are currently paying more than two percent. A short-term bond or Treasury fund is another investment option, but these are not FDIC insured and can lose in value.

The next step is to determine your risk tolerance and time horizon, as that information will determine the percent invested in stock funds versus bond or fixed funds. This exercise can be completed with your financial advisor or on your own with a risk tolerance questionnaire.

Depending upon the results, you’ll invest anywhere from 20 percent to 90 percent in stock funds, with the remainder in bond funds. Aggressive investors, or those that have many years before they’ll need the money, have higher percentages allocated to more volatile stock assets. You might also consider a small allocation to other types of investments. Here’s a typical 60% stock, 40% bond portfolio allocation.

60 40 portfolioWithin the stock category you might include:

  • U.S. S&P 500 large cap funds
  • U.S. mid-cap stock funds
  • U.S. small-cap stock funds
  • International Developed stock funds
  • Emerging Market stock funds

Within the bond category you might include:

  • Government bond funds
  • Corporate bond funds
  • High yield bond funds
  • Municipal bond funds (for taxable accounts)
  • International bond funds

With a small portion of your investable assets you might consider:

  • Real estate investment trusts (REIT)
  • Commodity funds
  • Alternative asset classes
  • Real estate crowdfunding
  • Venture capital
  • Hedge funds

Your future returns are typically a function of your asset allocation.

Typical portfolio returns
Chart source: Fidelity Data source: Ibbotson Associates, 2018 (1926-2018)

This information can help you understand the potential risk and return of your asset allocation decision. Although, historical performance information is only a guide, and future returns can be different.

7. Which accounts should you invest your inheritance?

If you don’t already have a retirement account, such as a 401(k), 403(b), Roth or Traditional IRA, now is the time to open one, unless you are past age 70. Retirement accounts protect your assets from taxation. The traditional IRA, 401(k), and 401(b) also save on taxes when funded, as the money contributed to the account is pre-tax. Only the withdrawals from the accounts are taxable.

For 2019, employees can contribute up to $19,000 per year and those over age 50 can add an additional $6,000 to a 401(k) or 403(b) account.

Roth IRAs are funded with money you’ve already paid tax on. Yet, if withdrawals occur after age 59 ½, they are tax-free. For 2019, you can contribute up to $6,000 or $7,000 if you’re age 50 or older. In 2019, total contributions to Roth and traditional IRAs can’t exceed $6,000 or $7,0000 if older than age 50. If you are covered by a retirement plan at work, then your contribution to an IRA may be limited.

After maxing out your retirement accounts, invest additional money in a brokerage account. Your financial advisor typically manages your assets housed in a brokerage company such as TD Ameritrade.

At this point, you might want to consult your estate planning attorney to review your current plan and determine whether to create a trust. If a trust is deemed appropriate, then your investments will be held in the name of the trust in the investment brokerage account.

8. What are the Tax Consequences of a Large Inheritance?

Bull Oak Tax Efficiency

Estates valued at less than $11,400,000 in 2019 are not required to either file a federal estate tax return or pay taxes. A handful of states levy an inheritance tax. Fortunately, California does not charge either an inheritance or estate tax.

If you sell assets within the estate, there may be tax consequences. Fortunately, inherited assets receive a step up in basis. When you inherit stocks or bonds from Mom, the value or basis of those assets isn’t the amount that she paid, but the value of those assets on the day of her death.

If you sell a stock, bond or fund, that has appreciated since you acquired it, then you’ll pay capital gains tax. If that asset paid any dividends after Mom’s death, you’re liable for the tax due on the dividend payment. In most cases, the tax consequences of a large inheritance are minimal.

9. Watch out for Lifestyle Creep

Be mindful of your lifestyle when you inherit money. It’s easy to allow your lifestyle to creep upwards with lavish trips, expensive cars, and extreme spending. Although, there’s nothing wrong with a splurge, watch out for excessive spending after receiving an inheritance.

Adopting the “I deserve it” mantra after receiving an inheritance can create overspending and deplete your finances. The internet is full of stories the wealthiest people, living beyond their means. After receiving your inheritance, take a portion of the money for a special splurge, and then, return to a reasonable lifestyle that aligns with your values.

Finally, investing a large inheritance requires foresight, a clear head, and smart decision-making. Don’t feel that you must ‘go it alone.’ A financial professional is well worth the fee to make sure that you’re acting in your own best interest.

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