If you've ever read a story about what someone does with a financial windfall, it's likely featured a truly life-changing amount of money. It can be fun to daydream what life would be like if you hit the Powerball for $1.7 billion, but for most people, windfalls aren't quite as exciting.
Take inheritances. Sure, some people inherit Grandpa Winston's wine collection or Great Aunt Millie's furs — and all the money that comes with it. But the average American inheritance across all age groups and incomes between 2001 and 2019 was just over $12,000, according to a University of Pennsylvania analysis of data from the Federal Reserve's Survey of Consumer Finances.
That number is dragged down by the vast majority of Americans who received no inheritance at all. Among those who did receive one, the average was about $184,000 — a healthy sum, but not enough to retire.
In other words, if you are lucky enough to receive an inheritance, you'll have to fold that money into your financial plan, which, depending on what form the inheritance takes, can be a lot of work.
Inheritances come in three primary forms: cash, real estate and investments.
"Ideally, it would be cash, but when you look at a typical inheritance in the United States, it's usually some mix of those three," says Clay Ernst, executive director, financial planning at Edelman Financial Engines.
Here's how financial pros say to handle all three.
How to handle a cash inheritance
Cash is the easiest asset to handle, as long as you're not receiving a boatload of it. For 2023, you won't owe federal taxes on any cash you inherit up to $12.92 million.
"Cash is the easiest type of inheritance to receive," says Pratik Patel, managing director and head of family wealth strategies with BMO Family Office. "We're not worried about the tax consequences of a sale. We're not worried about basis. It's your money to do as you see fit."
So what should you do? If your financial plan is completely bulletproof and this money is just gravy to you, feel free to take a fabulous vacation or buy yourself something nice. For the rest of us living in reality, there's likely some work to do.
If you don't have an emergency fund, maybe this is your chance to create one.
Another priority: Tackling high-interest rate debt. "You probably want to pay that off right away," says Patel. "These are double-digit rates that will typically exceed the kind of returns you'll get in the stock market."
If you have expensive debt paid down, you may want to consider paying off low-rate debt or investing the money, says Patel. "You might want to put it in something as simple as an ."
How to handle inheriting real estate
Unless your parents lived in a palace, you're unlikely to run into the inheritance tax limit on a real estate inheritance either. And thanks to a rule known as a step-up in basis, you likely won't owe any tax on property you inherit — not initially anyway.
The tax rules are such that the value of an inherited home resets when the owners die. If Mom and Dad paid $100,000 for a house and sold it for $500,000 while they were living, they'd owe tax on the $400,000 gain.
But when they die and leave the house to you, the value of the house for you (also known as your basis) is the fair market value of the house — $500,000. If you sold it for that amount, you wouldn't realize a gain as far as the IRS is concerned.
"But the clock is ticking," says Ernst. "There's the step-up in basis at the time of death, but the estate settlement process can drag on for six or 12 months. Real estate values change and the market can change."
Plus, a house can't be divvied up quite as neatly as cash. If you have siblings, some may want to sell the home for cash. Some may want to rent it out. Some may want to move in.
That's why it's wise to get the property appraised as soon as possible, says Ernst. And opt for at least two appraisers, he adds. "One is always going to be higher than the other. If you have two you can take the average. If you have three, you can take the middle one."
Getting the appraisals will make life easier for everyone if, say, one sibling wants to buy the others' share of the home. It also gives you a baseline number to keep in mind while deciding when and how to sell the home.
You may decide that you want to wait for a hotter housing market to make a sale. But remember: Real estate often comes with upkeep costs, says Patel.
"Until you liquidate and sell, you are taking on an additional obligation, which can oftentimes negatively affect your cashflow," he says. "People underestimate the expense in real estate, so you should be aware of that prior to making the decision."
How to manage inheriting investments
Like real estate, any investments that you inherit in a taxable account come with a step-up in basis. Even if your parents paid $10 for their Apple stock, you're getting it at its current market value today. "You can then sell it at its basis, and it's cash for all intents and purposes," says Patel.
If you don't sell right away and hang on to those investments, the rules apply just as if you had bought the stock at market value. You'll owe tax on any gains you realize.
The rules get trickier when you get into different types of retirement accounts. The main thing to keep an eye on: plans that your relatives funded with pre-tax dollars, such as 401(k)s and traditional IRAs.
"Now I have to pay tax when I pull that money out," says Patel. "And when I pull that money out, that stacks on top of my income I've already earned. If I'm in my peak earning years, that's subject to potentially the highest tax rates in a given year."
Generally, the IRS gives you a 10-year window to take that money out, which gives you some wiggle room with tax planning. A different set of rules and conventions apply to Roth accounts.
Overall, to make sure you're inheriting money in a tax-efficient way, you'd be wise to bring in some advisors, says Ernst.
"Throughout this process, you'll want to engage professionals: a tax advisor and generally an estate planning attorney," he says. "Especially for more complex estates, that would be the thing to do."
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