Inheritances are relatively rare, affecting about 20 percent of U.S. households, but that still amounts to millions of people who need to decide how to manage them.

Here’s how to make the most of an inheritance by investing it wisely.

How to get started investing an inheritance

So, what exactly is an inheritance? An inheritance is the transfer of assets from one person to another following their death. These assets can include property such as a house, cash, investments, jewelry, and other valuable items.

Inheritances are given to either a beneficiary (someone named in a will) or an heir, such as a child or surviving spouse.

Receiving an inheritance, especially a large one, can feel like hitting the jackpot. It can provide financial security and open up new opportunities for you and your family. However, it’s crucial to handle this newfound wealth with care and a solid plan. Jumping into investments or making significant purchases too quickly can lead to unfavorable financial outcomes. Here are some steps to consider when you’re ready to start investing your inheritance:

Take it slow and make a plan

When you receive an inheritance, it’s important to proceed with caution and a well-considered plan.

Start by assessing your current financial situation to understand how the inheritance fits into your life. Prioritize its use by addressing any high-interest debt, such as credit cards or personal loans, and ensure you have a sufficient emergency fund—ideally covering about six months of expenses.

Once these immediate needs are addressed, you can focus on investing the remainder of your inheritance. Investing can help you build wealth that might not have been achievable otherwise.

Consider diversifying your investments across various asset classes, including stocks, bonds, and funds. You might also explore additional options like real estate, gold, cryptocurrencies, or other alternative investments.

Get advice if you need it

Investing an inheritance can be challenging, particularly because it’s often a new experience for most people, making the process both unfamiliar and emotionally charged.

It’s perfectly okay if you don’t have all the answers right away. In fact, seeking professional financial advice can be highly beneficial. A financial advisor can help navigate the complexities, avoid common pitfalls, understand the tax implications, and develop a comprehensive investment strategy tailored to your goals.

Part of this process might involve restructuring your investments to align with your strategy, and once that’s done, you could potentially automate your portfolio.

When selecting an advisor, ensure they are a fiduciary, have relevant experience, and provide a transparent payment structure. This ensures they have your best interests in mind and can offer impartial, expert guidance.

What to do with inherited investments

Inherited investments refer to any investment assets passed on to a beneficiary or heir. This could include individual stocks and bonds, or an entire investment portfolio containing a mix of stocks, bonds, mutual funds, and ETFs. Some companies also have equity-sharing programs that grant shares of company stock to employees as part of their retirement benefits.

One crucial aspect to remember with inherited investments is the potential tax implications. The good news is that you won’t be responsible for taxes on inherited stocks or investments because the tax liability is on the estate. Inherited investments receive a stepped-up tax basis, which adjusts the cost basis to the value at the time of inheritance, allowing you to avoid capital gains taxes on any appreciation that occurred during the previous owner’s lifetime.

However, if you sell the inherited shares, you will be liable for taxes on any gains realized after the inheritance.

Another key consideration is required minimum distributions (RMDs) if you inherit an IRA from someone other than your spouse. In this case, you must withdraw the entire value of the IRA over time. If the IRA is a traditional IRA rather than a Roth IRA, the RMDs will be taxed as income. This means you could face a significant tax liability if you inherit a traditional IRA with a substantial balance.

What to do with inherited real estate

Another common inherited asset is property, such as a home. Inheriting a home presents both benefits and challenges. Deciding what to do with the property can be complex, especially if the home holds significant sentimental value and emotions are involved.

You generally have three main options: sell the home, rent it out, or live in it. Each choice has its own advantages and disadvantages.

Sell the home

Selling the home provides the immediate benefit of a cash influx, which you can use for various purposes, such as paying off debt, investing, or purchasing other real estate properties.

Additionally, inherited homes come with a stepped-up tax basis, meaning you won’t pay taxes on the entire value of the home. Instead, you’ll only owe taxes on any profit made above its value at the time of inheritance. For example, if the home was worth $200,000 when you inherited it and you sell it for $250,000, you’ll only pay taxes on the $50,000 gain.

Rent the home

Renting out an inherited home is similar to managing any other rental property. It can provide a steady cash flow, which is a beneficial option and helps diversify your income as you work on building wealth.

However, keep in mind that the property will require maintenance, which might necessitate regular visits unless you hire a property manager. Additionally, handling taxes on rental income can be complex.

Live in the home

Choosing to live in the inherited home can be a great option if homeownership is something you’ve long desired but couldn’t previously afford. Since many banks require a substantial down payment for a mortgage, living in an inherited home can help you bypass this financial barrier. However, remember that homeownership comes with ongoing responsibilities, including property taxes and regular maintenance.

Ready to invest your inheritance money? Consider stocks, bonds and funds

While it might be tempting to keep your inheritance in cash or a money market account, this approach may not be ideal for maximizing your windfall’s potential.

To make the most of your inheritance, consider investing in stocks, bonds, and funds. If you’re new to investing, start by answering a few key questions:

  1. What is your risk tolerance?
  2. When will you need the money?

Risk tolerance refers to how much risk you’re willing to accept in exchange for potential returns. Investments typically involve some degree of risk. If a significant drop in your portfolio’s value would cause you considerable stress, it might be wise to opt for lower-risk investments.

Your time horizon is also crucial. It affects where you should place your money. For instance, retirement accounts generally have penalties for withdrawals before age 59½, so contributions should come from funds you won’t need until then.

Additionally, high-risk investments may not be suitable if you need the money within five years. Such investments can be volatile and may take time to recover from downturns. Although they can offer substantial long-term growth, a short time frame might not allow enough recovery time if the market declines.

Here’s a quick overview of low-risk versus high-risk investments:

  • Low-risk investments: These are typically more stable and offer modest short-term growth. They include Treasury notes, high-quality corporate bonds, and money market funds. They are suitable if you need access to your money within five years.
  • High-risk investments: These are more volatile and generally require a longer time to grow. They include initial public offerings (IPOs), high-yield bonds, individual stocks, and cryptocurrencies. While they have higher growth potential, they are better suited for longer-term investments.

How to use tax-advantaged accounts to minimize taxes

When investing an inheritance, it’s beneficial to utilize tax-advantaged accounts whenever possible. These include retirement accounts like Individual Retirement Accounts (IRAs), Roth IRAs, 401(k)s, and 403(b)s. Depending on the type of account, you may receive valuable tax breaks on contributions or withdrawals.

Here’s a brief overview of the benefits of different tax-advantaged retirement accounts:

  • Traditional IRA: Contributions may be tax-deductible, and taxes on any growth are deferred until you withdraw the funds. Withdrawals are taxed as ordinary income.
  • Roth IRA: Contributions are made with after-tax dollars, but any gains are tax-free if withdrawn in retirement.
  • Traditional 401(k): Contributions are tax-deductible, and taxes on growth are deferred until withdrawal. Withdrawals are taxed as ordinary income.
  • Roth 401(k): Contributions are made with after-tax dollars, allowing for tax-free growth and tax-free qualified withdrawals in retirement.

The primary difference between Roth and traditional accounts is when the money is taxed. Traditional accounts tax withdrawals as income, while Roth accounts tax contributions as income but offer tax-free withdrawals.

Choosing between a Roth and a traditional account depends on various factors, including your future income and tax bracket. Generally, if you expect your income in retirement to be higher than it is now, a Roth account might be more advantageous. Conversely, if future tax rates drop compared to today’s rates, a traditional account could be better.

Since future tax rates are unpredictable, it’s challenging to definitively say which account type is superior. Instead, focus on estimating your retirement income and tax situation to make the best choice for your circumstances.

In Conclusion

Receiving an inheritance can be overwhelming, especially when it includes a substantial sum of cash, investments, property, and other valuables. Figuring out the best way to manage all these assets can be challenging. Don’t hesitate to seek guidance from a financial advisor if you need assistance. An inheritance can significantly enhance your financial situation, but only if managed effectively. Consider using your inheritance to pay off debt, establish an emergency fund, and make strategic investments—these are often the most beneficial steps to take.