While you can't plan on receiving an inheritance, if that happens, what should you do? Above all, don’t rush to act - especially if you're in the midst of the grieving process. It can be hard to make good decisions about money.
You may want to consider “parking” your inheritance temporarily in cash while you can think about what to do. Here are a few ideas:
- Get rid of debts. Use your inheritance to pay off debts, especially consumer loans that aren't tax-deductible and that carry high interest rates. You may want to use part of it to pay off student loans, if that's your situation.
- Establish an emergency fund. This should be six to 12 months’ worth of living expenses. Without it, you may be forced to dip into your investments to pay for unexpected costs, such as an expensive car or home repair or a hefty medical bill.
- Review your financial strategy. If your inheritance is large enough, it may be a “game changer” in terms of your financial strategy. For example, you might be able to think about retiring earlier, if that’s what you want. Or pay more of your children’s college education. Or put a down payment on a house. Your financial advisor can help you make the most appropriate moves for your personal strategy.
- Plan for taxes. Unless you're “inheriting” your spouse’s assets, you may be subject to taxes. Some types of inheritance, such as life insurance policy proceeds, are tax-free. On the other hand, if you inherit a 401(k) plan from someone other than your spouse, you'll likely have to take the money as a lump sum, which means your inheritance will be subject to federal, state and local income taxes. However, you can transfer an inherited 401(k) to an IRA, which allows you to avoid immediately paying taxes on your inheritance. You’ll still have to take annual withdrawals, which are taxable, but the amount will be based on your life expectancy, so you can spread out the taxes. If you receive an inherited 401(k), consult with your tax advisor on the right approach for you.
And have some fun. It's likely the person who left the inheritance cared about you and your happiness. So, as you think about what to do with the money, remember it's OK to have a little fun.