Plan With Your Partner - What to Do With Inheritance Money
Receiving an inheritance can be exciting and overwhelming. Not only are you grieving the loss of your loved one, but now you must determine what to do with an inheritance. You might receive an inheritance from your parents or another loved one, but the key is to know what to do with it.
One wrong move when you inherit money, and it can hurt your financial future instead of helping it. Here's what you should know about planning with your partner to properly handle a substantial inheritance.
Note: This article is for general, informational purposes only. Please consult your legal or tax professional to understand your specific situation, options, and potential outcomes.
What Is an Inheritance?
An inheritance refers to assets you receive from a loved one's estate when they die. Estates can include cash, investment assets, physical assets, and more — even property.
For example, you might receive a lump sum of cash, an inherited property, or your loved one's favorite belongings, such as jewelry or other collectibles.
Anything you receive as a part of the estate is important, but knowing how to handle any money inheritance so that it helps rather than hurts your personal finance situation is vital.
How Does Inheritance Work
You can get an inheritance in many ways. Most commonly, your loved one leaves a will with specific instructions regarding who receives which assets. In some cases, though, the courts get involved and govern who receives the money, especially when there isn't a will present or when it is contested
How to Claim Inheritance Money
For the inheritance process to begin, the will must go through the probate process. First, the probate court reviews the will and named executors. Then, the court authorizes the executor(s), and the assets get transferred to the named beneficiaries.
Note that if your loved one used a trust instead of a will for their estate, you typically do not have to go through the probate process.
How Do You Receive Inheritance Money
The executor will determine how to transfer the money a beneficiary inherits. For example, they might electronically transfer the funds if it's a large sum. If not, you may receive a check for your inheritance.
How to Deposit a Large Cash Inheritance
It's important to keep your inheritance safe, especially if you receive a large inheritance. The more money you receive, the more important it is to keep it safe, such as immediately placing it into a savings account or CD until you know how you want to handle it.
Types of Inheritance
Inheritances can come in many forms, but here are the most common.
Inherited Wealth
Most inherited wealth is cash, but in some cases, you might inherit a retirement account. Retirement account like a 401(k) or Roth IRA usually don’t need to be included in a will or trust, as the account holder names a beneficiary to that particular account, and it passes to them automatically.
You typically won't have to worry about inheritance taxes if you receive cash. The estate tax exemption for 2022 is $12.06 million, and for 2023 is $12.92 million, and this affects a very small percentage of estates. Even so, if federal estate taxes are levied, it's the estate's responsibility, not the beneficiary's.
But if you receive a retirement account, your withdrawals (including any account earnings after your inheritance) may be subject to tax. This is most common when the retirement account was funded with “pre-tax” dollars, as with an IRA or 401(k).
Inherited Property
Inherited property refers to any physical assets your loved one's legacy left behind. This may include real estate or personal possessions, such as jewelry, antiques, or other collectibles. You choose what to do with the property you inherit, whether you sell it or keep it. However, if you keep it, understand that you become liable for any relevant property taxes, insurance, and home upkeep.
If you sell the assets, you'll pay capital gains tax on any profits you make. But in calculating your profit, the asset's original/starting value is based on its value on the day of your loved one's death. So if one sells an inherited property soon after they inherit it, unless there was a big swing in the property’s value, the tax implications shouldn't be too bad.
Inherited Stocks
Like property, inherited stocks don't incur tax liabilities unless you make capital gains during your lifetime. The 'original stock value' (in calculating your profit/gains for tax purposes) becomes the value on the day your loved one dies. Any capital gains you make from the day your loved one died until you sell them become a potential tax liability.
Inherited Debt
Beneficiaries don't directly inherit personal debt. Instead, the estate must take care of them before distributing any assets to the beneficiaries.
Inherited Annuity
A loved one can name you a beneficiary on their annuity, which allows you to receive payments after their death. The payments are not necessarily tax-free, though; you may be responsible for the taxes on any payouts from or earnings of the annuity. Note that tax and inheritance laws can be complex and nuanced, so be sure to consult your attorney or tax professional to understand the specifics of your situation.
Planning What to Do With Inheritance Money With Your Partner
It's important to determine what to do with an inheritance before you receive it or shortly after. Take your time and think about how you'll handle it, but don't let too much time pass that allows for poor financial decisions.
Grieve Your Loss
Most importantly, take the time to grieve your loss. Receiving an inheritance puts a lot of stress on you, but you must process the feelings of losing your loved one first. Making important financial decisions when you're flooded by your emotions and not in your usual frame of mind can lead to mishandling your inherited assets.
Seek Professional Advice
It's a good idea to get an objective opinion regarding handling inherited assets, especially if you're grieving. Even if you received an average inheritance, a certified financial planner or professional could help determine the best way to invest an inheritance. You can choose to work with the financial planner or professional already handling the estate or hire a new financial advisor.
Establish Goals
Being on the same page with your partner about handling the money received is important. A few common goals include:
Setting up your child's college fund
Putting money aside for an emergency fund
Investing in your retirement accounts
Pay off debt
Buy a house
You might have different ideas of what to do when inheriting money, but together you can devise a compromised plan that honors both partners.
Use an Insured Account
While deciding what to do with a large inheritance, ensure you park the money in an insured account. If you receive an inheritance larger than $250,000, consider spreading the money out between different accounts so you have insurance coverage (i.e. from the FDIC) on the entire amount.
Talk Taxes
It's never fun, but you must discuss how inherited investments affect your taxes. Working with a tax professional is ideal because they can help you determine the optimal way to receive investments so as to avoid a situation where you owe taxes (or at least any more taxes than necessary).
Even if you inherit tax-advantaged retirement accounts, you may face tax consequences, so always talk to a professional.
Invest
Investing inheritance money is a great way to make it grow. If you don't know how to invest an inheritance, work with a financial advisor to ensure you make smart choices.
Pay Off Debt
If you have a lot of high-interest debt, you might want to use your inheritance to pay it off. Most investments won't outperform the interest rates you pay on debt. Even if you don't use the entire amount to pay your debts, consider using some of it to get a head start.
Build Up Your Emergency Fund
If you haven't built up an emergency fund before you receive an inheritance, consider using it to start an emergency. I recommend having three to six months worth of expenses to cover life's costs if you lose your job or fall ill. When you receive a large lump sum of money is a great time to get that fund going.
Inheriting Wealth FAQ
What Is Considered a Large Inheritance?
The definition of a large inheritance is subjective, but most people agree that any amount over $100,000 is considered significant.
Do I Have to Pay Taxes on Inherited Money?
You typically won't pay federal estate tax on inherited cash money. However, any earnings you make from the inherited money is taxable. For example, if you receive an inheritance, invest it in stocks, and then sell the stocks for a profit, you'll pay capital gains taxes on the net earnings.
Can Debt Be Inherited?
Fortunately, inheriting personal debt typically isn't an issue. The estate must take care of the debts, as appropriate, before distributing any inheritances. However, if a debt is shared, such as with a surviving spouse, then the debt may become the responsibility of that spouse.
What Is the Best Thing to Do With an Inherited Annuity?
If the inherited annuity has higher fees than your traditional IRA or Roth IRA, then you consider rolling over the inherited annuity into into that account. Many IRAs have lower fees and more investment options than annuities, but review the prospectus and any other relevant information to be sure.
The goal would be for rolling the annuity into your traditional IRA or Roth IRA to give you more options for how you handle the money while keeping a larger portion of your inherited investments due to lower fees and/or by using tax-advantaged accounts.
Does an Inheritance Count as Income?
The IRS doesn't consider an inheritance as income. However, if you earn money on the inheritance — in other words, you make the money grow — then it becomes taxable income. Distributions from certain accounts may also be taxable, i.e. where the person who funded that account got a tax advantage initially. Speak to your attorney or tax professional to understand your specific situation and options.
Note: This article is for general, informational purposes only. Please consult your legal or tax professional to understand your specific situation, options, and potential outcomes.
What to Do With Inherited Money: The Bottom Line
When deciding what to do with an inheritance, take it slow. Don't make rash decisions, and consider getting financial advice. Your financial plan may change drastically depending on the size of the inheritance, but you must handle it correctly so that you keep the largest amount of your money and/or get the most benefit from what you’ve inherited.
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Adam Kol is The Couples Financial Coach. He helps couples go from financial overwhelm or fighting to clarity, teamwork, and peace of mind.
Adam is a Certified Financial Therapist-I™, Certified Mediator, and Tax Attorney with a Duke Law degree and a Master's in Tax Law from NYU. He is a husband, dad, and musician, as well.
Adam's wisdom has been shared with The Wall Street Journal, the Baltimore Ravens, CNBC, NewsNation, and more.
