The best thing to do with a large inheritance depends on what kind of financial planning you’ve already done, whether or not your inheritance is in a trust and if the money you’ve inherited is currently invested in tax-advantaged accounts, such as an IRA or in a taxable account. If any of these situations apply to you, read on to learn how best to handle your windfall.
Getting your team in place
Inheriting a lot of money can be scary, and even if you have a lot of investing experience, there are plenty of tax and legal pitfalls that can trip you up.
Because of the complexity associated with where to put an inheritance, it’s helpful to hire experts early on to help you navigate the ins and outs of making the most of the money that’s been left to you.
Depending on what kind of financial planning you’ve already done, you may already have this network in place. If you don’t, then avoid the temptation to go it alone. Your recent loss could make it harder to spot and avoid making mistakes with your inheritance.
Here are some tips for building your team:
- If you want financial advice, focus on wealth management companies and interview at least three firms before becoming a client.
- There are a lot of accountants, but you should concentrate your search on those specializing in high-net-worth families. Depending on the inheritance, you could face estate taxes, inheritance taxes, or income taxes. In my opinion, this isn’t a time for off-the-shelf software.
- Similarly, there are plenty of lawyers who specialize in high-net-worth clients, so focus on trust and estate lawyers, not divorce or business attorneys.
Understanding what you’ve inherited
Are you inheriting a trust? IRAs? Cash? Your financial options differ for each of them.
For instance, if your inheritance is in the form of a trust, your windfall will often be managed by a trustee that isn’t you.
While trustees can be anyone, they’re usually an investment advisor, banker, lawyer, or another family member. Trust beneficiaries (like you) usually aren’t selected as sole trustees to avoid IRS scrutiny and, potentially, estate taxes.
The trustee is responsible for managing and distributing the assets held in the trust according to the trust’s language, so you should carefully read the trust so that you understand the trustee’s responsibilities. Also, don’t forget to provide the trustee with your contact information so that you can receive regular updates on the trust’s investments and performance.
If you aren’t inheriting assets held in a trust, but they’re in tax-advantaged accounts, such as IRAs or 401(k) plans, your options depend on if you’re a spouse or not.
If you’re a spouse and you inherit these accounts, you can transfer them into your name and treat them as your own or take a lump-sum payout. Often, transferring them is your best bet because traditional IRAs and 401(k) plan contributions are usually made with pre-tax money and therefore withdrawals are subject to income taxes. Also, the longer assets stay in these accounts, the more they benefit from tax-advantaged growth.
If you’re the account holder’s spouse and you inherit a Roth IRA or Roth 401(k), you have the same options. However, Roth contributions are made with after-tax money, so withdrawals from them won’t be subject to income tax, as long as the account’s been open at least five years. If it’s been open less than five years, then any gains that are withdrawn will be subject to income tax.
Although withdrawals from Roth accounts might not be taxed, I still think converting these accounts to your name makes sense. Doing so lets you continue enjoying tax-free growth, and it can help you pass along more money to your heirs tax-free when you pass away.
If you’re not the spouse of the account holder and you inherit an IRA, your options are limited because the IRS forces you to withdraw the money that’s held in these accounts.
You have three options for withdrawing money in these accounts:
- Withdraw it over your lifetime
- Withdraw it within five calendar years following the year in which the account owner died
- Withdraw it as a lump sum
Since income taxes usually apply to traditional IRA and 401(k) withdrawals, I prefer using the life expectancy option for those accounts so that it spreads out your tax burden.
If it’s a Roth account that’s been open at least five years, you won’t get taxed on your withdrawals, but I still like the idea of withdrawing the money over your life expectancy. Doing so will still give you at least some benefits from tax-advantaged growth and legacy planning.
In any case, make sure you update your beneficiaries if you transfer these accounts into your name. If you end up withdrawing all the money at once and you have to invest a lump sum or you inherited cash, pay particular attention to this next bit of advice.
Embrace a financial timeout
It can be incredibly tempting to start spending your inheritance right away, but it can be smarter to establish a “spending timeout” instead.
Even the most financially savvy person can quickly spend an inheritance, and while you might think “not me,” studies show that one in three people spend all of their inheritance (and more) within two years. That’s frightening when you consider it takes a lifetime of saving to build up an inheritance.
To reduce the risk of falling into the one-third of people who spend their windfall too quickly, use the first few months following your inheritance to develop a spending plan with your team of financial advisors, accountants, and lawyers. They can help you learn from others’ experiences, decide what’s most important to you, and craft a plan that helps you limit the risk of outliving your money.
How to invest your inheritance
Regardless of whether you hire an investment advisor or go it alone, it’s important to know that you have a lot of investment options, and those options all come with their own share of things to consider and risks to understand.
For instance, mutual funds are often managed by big, stable firms with lots of experience, and oftentimes, they offer break points that reduce your fees depending on how much money you invest. However, mutual fund performance can vary widely, and some mutual funds charge more in annual fees than others. Additionally, mutual funds can be sold in different share classes with different costs, so if you’re not careful, you could end paying more for a mutual fund than you need to.
The expenses associated with investing in exchange-traded funds (ETFs) are often less than mutual funds, but most ETFs rely on passive investment strategies that track the holdings of specific indexes, such as the S&P 500. Because ETFs are usually managed passively, you miss out on the potential outperformance that can come from investing in actively managed mutual funds or picking individual stocks.
Speaking of individual investments, they can be a great way to build a long-term portfolio, too. If you use a discount broker, investing in individual stocks and bonds can be less expensive than mutual funds and ETFs over the long haul, and it can give you more flexibility to build a portfolio that’s right for you. However, individual securities can be very risky, and if you pick the wrong investment, you can suffer big losses.
It can be even riskier to invest in commodities. Yes, commodities provide you with direct exposure to things like food (grains), energy (oil or gas) and metals (gold), but investing in them can be expensive, and since commodities are cyclical, they can go through long periods where they underperform other assets.
One more thing to keep in mind
It’s common for a big windfall to come with a lot of requests from family and friends, and it’s important to keep these requests in the proper perspective. Sometimes, helping out a family member or friend financially can cause friction that ends up ruining that relationship. To reduce the risk of that happening to you, don’t be afraid to lean on your team of advisors as a go-between. They can help you figure out what requests make sense and what don’t.
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