Investing an Inheritance for Income.
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Table of Contents
Introduction
Financial security is not always assured by receiving a sizable inheritance, so it’s best to know how investing an inheritance works. A drastic change in lifestyle and illogical behavior may result from an abrupt cash inflow. Believe me, it’s effortless to squander a fortune without any plan.
But, what is an inheritance?
The term inheritance describes the possessions that a person leaves to their cherished ones after they pass away. Cash, investments like stocks or bonds, and other things like jewelry, cars, works of art, antiques, and real estate can all be included in an inheritance. The recipient of an inheritance can be an heir, who could be a kid or surviving spouse, or a beneficiary, which means someone designated in a will.
Investing an Inheritance: How to Get Started
It is crucial to give consideration as to how the inheritance will be used. The hows of investing an inheritance to get the most out of it is provided below.
It makes sensible to take care of any high-interest debt first, including credit card debt and personal loans. The same is true if you don’t have or have a small emergency fund, which should be enough to cover roughly six months’ worth of costs.
You should think about investing the remaining portion of your inheritance after taking care of these basic needs. You can achieve wealth-building that might not have been possible in any other way by doing this. Make sure your assets are diverse if you decide to invest a huge amount of money you received as an inheritance.
This entails investing an inheritance into a range of stocks, bonds, and funds. Investing in different asset classes, such as gold, real estate, or other alternative assets, is something else you might want to think about doing. Adding some other investments to the mix can serve as a helpful hedge, even if the majority of investors invest primarily in domestic companies.
While it is feasible to store cash or have your inheritance windfall sit in a money market account, which is an interest-bearing account at a bank or credit union, that would not be the best course of action.
You should think about investing an inheritance stocks, bonds, and exchange-traded funds (ETFs) if you want to get the most out of it.
Determining your risk tolerance and when you will need the money are vital if you don’t know where to begin and if you don’t have much (or have zero) experience investing.
The level of risk you’re willing to take on in exchange for a reward is known as your risk tolerance. For the finest investments, you need to be at least somewhat risk-tolerant. Lower-risk investments are generally a better idea if you would experience significant stress from seeing your portfolio lose 10 or 20 percent of its value.
Because of a few factors, knowing when you need the money is crucial. Where you keep your money could be determined first. For instance, with few exceptions, it is typically not permitted to withdraw funds from a retirement account prior to the age of 59.5 without being subject to a 10% penalty. As a result, if you are making contributions to a retirement plan, they should typically be made with funds you won’t require before that age.
But there is another factor to consider when determining your time horizon, that is, if you need the money in less than five years. If so, high-risk investments are typically not a viable decision for you. This is due to the possibility that, depending on when you made the investments, their value could slump and take years to get better. If your time horizon is brief, you might not have sufficient time to wait for the value of your investments to climb again, even on the occasion that they end up jumping way higher that they did before plunging.
Low-risk investments are typically more steady and have the potential to grow modestly over the short term. Although they have a reduced long-term growth potential, this is unimportant if you need the money now rather than in the next five years. Treasury notes, top-notch corporate bonds, and money market funds are examples of low-risk investments.
On the other hand, high-risk investments involve much higher volatility and longer growth times. They are more risky, but they have the potential for longer-term increase. Initial Public Offerings (IPOs), high-yield bonds, and individual stocks are among some of the popular investments with a high degree of risk.
Investing an Inheritance: Inherited Investments
What can you do with inherited investments?
Investments that have been left to a beneficiary or heir are referred to as inherited investments. As a result, you might inherit certain stocks and bonds or an investment portfolio that includes a combination of individual stocks and bonds, mutual funds, or ETFs. Some businesses offer their employees equity-sharing plans whereby they might receive shares of company stock as a retirement bonus, which could also be an inherited investment.
Being the recipient of an investment inheritance could get a little overwhelming, especially if you are a novice investor. You can talk to me to help you sort through such investments.
Restructuring the investments to fit a plan that advances your objectives may be one step in this approach. The good news is that once that procedure is over, you might be able to completely automate the portfolio.
When dealing with inherited investments, it’s crucial to consider any potential tax repercussions. Since the estate bears the tax burden on inherited stocks though, you will not be responsible for paying taxes on your windfall. Any investments you obtain have a stepped-up tax basis, which means the cost basis is changed to the price at the time of the inheritance. This enables you to avoid paying capital gains taxes on the appreciation that occurred over the former owner’s lifetime. If you do sell your shares, you will be responsible for paying taxes on any profits you make after that.
If you inherit an individual retirement account (IRA) from someone other than your spouse, another material thing to consider are required minimum distributions (RMDs). You will need to gradually withdraw the entire amount of the IRA in this situation. Additionally, those RMDs will be taxed as income if the IRA is a regular IRA rather than a Roth IRA, which is an individual retirement account that allows for growth and withdrawals that are not levied during retirement (subject to certain conditions). As a result, you can find yourself with a sizable tax obligation if you inherit a traditional IRA with a sizable balance.
Investing an Inheritance: Taxes
An inheritance may be worth several thousand dollars or many millions. In most nations, beneficiaries of an inheritance may be burdened with tax obligations since inheritance assets are subject to inheritance levies. The rates of an inheritance tax, sometimes known as a death duty, are determined by a variety of variables, including the beneficiary’s state of residence, the amount of the inheritance, and the beneficiary’s relationship to the deceased person.
Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania are currently the six states in the US with inheritance taxes. Additionally, the majority of these states exempt from inheritance taxes any assets left to a spouse after death. Children may also be free from taxes in particular circumstances or be subject to less taxes.
Meanwhile, the inheritance taxes owed by beneficiaries who are not connected to the deceased are often higher than those owed by beneficiaries who are. Relatives who were further removed from the deceased paid inheritance taxes of 13% on sums more than $15,000. Inheritance taxes were paid at a rate of 18% by all other beneficiaries, including friends and distant relatives, on assets worth more than $10,000.
Taxes on inheritance do not apply to life insurance. Consider purchasing a life insurance policy and designating your heirs as beneficiaries if you want to avoid paying inheritance taxes.
How can you utilize tax-advantaged accounts to trim taxes?
When investing an inheritance, it is wise to take advantage of tax-advantaged accounts whenever possible. These include retirement accounts such as an IRA, Roth IRA, 401(k), 403(b), and so on. Depending on the type of account, either withdrawals or contributions may come with valuable tax breaks.
The best course of action when investing an inheritance is to utilize tax-advantaged accounts wherever available. These include retirement accounts like a traditional IRA, a Roth IRA, a 401(k), a 403(b), and so forth. Withdrawals or contributions may qualify for considerable tax advantages depending on the type of account (such as for Roth IRA as mentioned prior).
The pros of tax-advantaged retirement accounts are summarized as follows:
- Traditional IRA: Taxes on any increase are postponed until withdrawal, which is subject to ordinary income tax. Contributions could also be tax deductible.
- Roth IRA: Contributions are levied as ordinary income, plus any gains are free of tax if they’re withdrawn in retirement.
- Traditional 401(k): Contributions are tax-deductible, and taxes on any growth are delayed until withdrawal. Withdrawals are subject to ordinary income tax.
- Roth 401(k): Employee contributions are made with after-tax dollars, resulting in tax-free withdrawals upon retirement. The balance may increase tax-free.
The timing of taxation is the main distinction between a Roth and a conventional IRA. Withdrawals from conventional accounts are subject to taxation as income. Contributions are taxed as income when used with Roth accounts. These accounts allow you to grow your money while leaving money in them for years or even decades without paying any taxes on the growth.
The question of whether it is preferable to invest in a Roth or regular account is one that is still up for argument, but it also depends on your own situation. Because of this, it is impossible to conclude one is superior to the other. Generally speaking, a Roth account would be beneficial if your income in retirement will be more than it is now.
Marginal tax brackets are one thing that can’t be predicted, though. A Roth will prevail if marginal tax rates rise from their current levels in the future because you pay taxes now but none later with a Roth. It goes without saying that a typical retirement account is preferable if taxes decrease in the future. The only thing we can try to estimate is how much money we will have in retirement because we don’t know what future marginal tax rates will be.
What can you do to escape inheritance taxes?
By putting your assets in a trust or giving assets to your beneficiaries while they are still alive, you might lessen the impact of inheritance tax on them. A different choice is to get life insurance and name your heirs as beneficiaries as there are no inheritance taxes owed on these payments.
Investing an Inheritance: Chapter 13 Bankruptcy
Will you be able to safeguard an inheritance from a chapter 13 bankruptcy?
Your trustee may order you to pay the amount into your bankruptcy plan if you receive an inheritance within 180 days of filing for Chapter 13 bankruptcy. On the other hand, inheritances received more than 180 days after filing for bankruptcy provide a more challenging situation. While most courts have determined that these inheritances must be given to creditors, other courts have allowed the inheritor to keep the money.
Investing an Inheritance: Real Estate
Property, such as a home, is another typical inherited asset. It can be both advantageous and difficult to inherit a home. It’s not always simple to decide what to do with that house, particularly if sentimental value is attached to it and feelings might get heated.
You essentially have three choices: sell the house, rent it out, or stay in it. There are advantages and disadvantages to each of these choices.
Placing the house in the market
The benefit of receiving a large sum of money up front when selling the house is clear. You can utilize that money for investments or paying off debt. You can also utilize the money to buy further real estate.
In addition, inherited homes have a stepped-up tax basis, meaning you don’t pay taxes on the entire value of the home. Instead, you pay taxes only if the home sells for more than it is worth at the time of inheritance. So if it was worth $200,000 when you inherited it and you sold it for $250,000, you only pay taxes on $50,000 of it.
Furthermore, inherited houses have stepped-up tax bases, which means you don’t have to pay taxes on the full value of the property. Rather, you only have to pay taxes if the house is sold for a value that’s more than how much it was inherited for. You would only have to pay taxes on $50,000 if you sold a home for $350,000 when it was worth $300,000 by the time you inherited it.
Renting the house
It’s not much different to rent out a house you’ve inherited vs renting out any other rental property. The emotional attachment that may still be bound to the home is most likely the biggest difference. Rentable properties can still generate cash flow, which is a desirable alternative as you amass wealth.
Taxes can be challenging as well and unless you hire someone to handle the property for you, do note that the house will require repair, which would necessitate trips back to the location.
Living in the house
If you’ve always wanted to be a homeowner but didn’t have the resources to do so, choosing to stay in the inherited home can be a wonderful choice. Living in an inherited property can be a way to get over the obstacle that many banks have that need a significant down payment before giving a mortgage. But don’t forget about real estate taxes and the apparently endless maintenance that frequently goes along with home ownership.
Investing an Inheritance: Bottom line
Getting an inheritance might be difficult in a variety of ways. It’s possible for you to acquire a sizable sum of money, investments, real estate, and other valuables all at once. As a result, it may be challenging to decide how to manage your inheritance.
Even though the items you inherit are essentially the same as any other financial asset, for some people, the experience might be daunting. Please don’t be hesitant to contact me if you think I can be of assistance. Your financial situation can benefit greatly from an inheritance, but only if it is well managed. Your best options will probably be investing an inheritance, paying off debt, and creating an emergency fund.
Pained by financial indecision? Want to invest with Adam?
Adam is an internationally recognised author on financial matters, with over 760.2 million answer views on Quora.com, a widely sold book on Amazon, and a contributor on Forbes.
