What to Do When You Receive an Inheritance

Perhaps the best advice on what to do when you've received an inheritance is not to do anything for a while. Depending on the amount of the inheritance, you will need some time to think about how it fits into your overall financial planning. And, you must see if you owe any taxes before you make other use of any money you inherit.

AARP advises parking the money you inherit in a stable, liquid account such as a money market account. You shouldn't rush into investment or spending decisions that you may regret later. You need a plan. Letting the emotion of a windfall overtake you could lead you to lose it or, worse still, make decisions that cost you money.

Using an inheritance
Set yourself a cooling-off period of at least a month, preferably longer. You may choose to allow yourself one indulgence, such a nice dinner or a moderately priced purchase for yourself or your home, not to exceed a few hundred dollars.

The key to managing any windfall, whether it be an inheritance, a sudden gain in an investment's value or lottery winnings, is to remember that this is not income. The money you receive is limited and will run out someday. Chances are you won't be able to radically alter your lifestyle, but you may be able to make some lasting changes to improve your financial future.

Start with paying off debts, particularly credit card debts that carry high interest rates. Once those debts are paid off, turn your attention to loans and mortgages. If an inheritance lets you pay off your mortgage, do it. You won't see an immediate financial benefit, but you'll be able to save more money from every paycheck.

If you don't have enough to pay off your mortgage completely, consider increasing your monthly payments to reduce the principal you owe, which will reduce the time it takes to pay off your mortgage and your interest rate. Make sure there are no penalties for paying off your mortgage early. With an increased share of ownership in your home, you may be able to refinance to a lower interest rate or eliminate private mortgage insurance.

Next, turn your attention to your retirement savings. Make the maximum contributions to your IRA, if you have one. If you're using a 401(k) or 403(b) at work, you can increase the amount deducted from your paycheck and use the inheritance to make up the difference in your take-home pay. This investment in your future won't improve things now, but it could pay off during retirement.

Starting or funding an account for college education expenses is another good option. Look into 529 plans and prepaid tuition plans for your children. One advantage of qualified retirement plans and college savings plans is that they reduce your taxable income, which can prevent a big tax bite when you need to claim your inheritance.

Don't spend the inheritance on home improvements or paying down car loans unless you already own your home, have your debt paid off and have made the maximum contributions to retirement and college savings plans. Cars depreciate in value, and some home improvements can harm the resale value of your home. Disposable expenses, such as vacations, expensive clothing and electronics are also a poor choice.

Investments and taxes
If you inherit a portfolio of investments, you may need to make some changes to adapt it to your particular needs. The portfolio may consist of more conservative investments oriented toward a retired person. If you are young, you may need more growth-oriented investments.

You should also be aware of the basis of your inherited assets for tax purposes. The basis is the amount that will determine your gain or loss if you sell those assets. Normally inherited assets have a stepped-up basis. This means they are valued for federal income tax purposes at their fair market value on the deceased's date of death or on a valuation date six months after the date of death.

This stepped-up basis exempts you from having to pay tax on the increase in the value of the asset up to the time that you inherit it. You only pay tax on the gain calculated as the difference between the amount you receive when you sell the asset and the stepped-up basis, not the original cost.

If you inherit a home or real property you will need to secure that property once you take title. You should review the existing insurance coverage, have it transferred to your name, determine whether it is adequate and make any changes needed. You will have to pay property taxes and take care of maintenance and repairs.

If you inherit jewelry, objects of art, collections or other items of value, you may need to find a safe place to keep them. Get a professional appraisal as soon as possible to find out their value, and then meet with your insurance agent to find out if supplemental insurance is needed. Most homeowners policies won't pay the replacement value of antiques, fine art and collectibles.

You need to gain a clear understanding of the taxes that apply to your inheritance. The federal estate tax is taken care of by the executor, out of the estate assets, before distributions are made to beneficiaries. You'll still be responsible for inheritance taxes, excise taxes and property taxes on real estate. The inheritance tax depends on the amount you inherit and your relationship to the deceased. A surviving spouse normally is not subject to inheritance taxes, but children, other relatives and friends could be. Inheritance taxes are levied at the state level. If you live in a different state than the one where the inheritance originated, you could wind up paying taxes to both states. Do some research on your state's Web site to find out the rules that apply.

If you inherit an IRA and you are the surviving spouse, you can continue to take advantage of tax-deferred earnings in the account. If you are not the spouse, you will have to begin receiving distributions as a beneficiary according to IRS rules. These distributions could be taxable as regular income, depending on the type of IRA.

With so much to think about, the best course of action may be to talk to a financial advisor or a CPA. These professionals can guide you through the maze of tax rules and help you make choices that will help your windfall improve your financial future.

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