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How to handle an inheritance

Follow these 9 steps to avoid making some common mistakes

Last reviewed: February 2011

Managing an inheritance can be emotionally and financially challenging. Just as you've lost someone close you must decide what to do with what may be the largest sum of money you've ever had. People often handle the situation poorly. "From my experience, 80 percent of all inheritances are spent within 10 years," says Kirk Kinder, a certified financial planner at Picket Fence Financial, which has offices in Florida and Maryland.

Here are nine steps to make sure you don't do anything rash or unwise.

1. Park the cash.

Put the money in an FDIC-insured money-market account at first. If it's more than $250,000—the most that deposit insurance will cover per account—divide it into multiple accounts in different banks. Don't put it in your existing checking account because that will make it too easy to spend. A more fail-proof method, recommended by David Barnett, a financial planner in Tustin, Calif., is to put the money in a three-month CD with a penalty for early withdrawal, so you'll be sure not to touch it for a while.

2. Hold the money in your name.

Don't put the money in a joint savings account with your spouse. Inheritances are separate property, so in community property states like California, your bequest won't have to be divided equally in the event of a divorce if it's kept separate from marital assets. And while you're at it, get your own estate documents in order. If you don't have a will and a power of attorney, get them.

3. Consult a financial adviser.

If you had bad financial habits before, a windfall might only accentuate them. Financial planners can help to create distance between you and the money, and even set you up with an allowance if you're concerned about the possibility that you'll squander it. Consider a fee-only financial planner, one who doesn't work on commission and shouldn't try to sell you investments you don't need. To find one, go to www.napfa.org, the website of the National Association of Personal Financial Advisors. Interview several before you choose one. An adviser can help you come up with a financial plan that will meet your financial goals, both short-term ones (big-ticket purchases, for example), and longer-term goals like retirement.

4. Cut debt and build a safety net.

Your initial impulse might be to use the money to pay off your mortgage. But higher-interest debt, like credit cards and personal and auto loans, should be tackled first. After that, consider building your emergency fund to at least six to 12 months' worth of living expenses. And since your newfound wealth might make you an attractive target for a lawsuit, increase the liability limits on your auto and homeowners insurance. Adding an umbrella liability policy if you don't already have one will supplement the liability protection on your homeowners and auto coverage by $1 million to $5 million.

At this point you might consider paying off some or all of your mortgage. But the decision will depend on the rate on your mortgage vs. the return you can expect to get putting the money elsewhere. If you're retired or coming close, it might make sense to use your inheritance to pay off your mortgage so you don't have that big payment to make each month.

5. Boost your savings.

If you're not already making the maximum contributions to your retirement plan, you should use some of your inheritance toward that end. If you meet the income requirements, you can also fund a Roth IRA. And if appropriate, you can put some money into a 529 college savings plan for your children or grandchildren. You might also want to invest in a regular taxable brokerage account. If in the next five years you expect to make any large purchases—such as a new car or home—you can set aside the money in a ladder of CDs or Treasury securities with different maturities.

Given the volatility of the stock market, it's smart to use dollar cost averaging for your new investments. Buy in increments over a period of 12 to 18 months. To help preserve your inheritance, look for relatively safe investments, such as bond funds and dividend-paying stocks. If income from your windfall will bump you into a higher tax bracket, consider tax-efficient mutual funds, such as index funds and tax-free bond funds.

6. Keep your job.

Some people think that a windfall will propel them into a different standard of living, but that will be true only if it's a vast sum of money, say several million dollars. In most cases, you shouldn't quit or retire early or you'll blow through your bequest before long.

"People do best when they plan to have a gradually increasing standard of living," says David John Marotta, president of Marotta Wealth Management in Charlottesville, Va. "Limit your spending to what would be a safe withdrawal rate, spreading the one-time windfall over the rest of your life." He suggests increasing your annual spending by less than 4 percent of the windfall each year.

7. Learn to say no.

There will be plenty of time to give money to family members, friends, charities, or religious institutions. Avoid financial salespeople, especially those selling annuities and other insurance products, and the investment adviser at your bank.

8. Consider fees and taxes.

If you inherit assets other than cash, the amount you get might turn out to be less than you expect after you sell them. For example, if your parent leaves you a house assessed at $500,000, you'll probably have to pay a real-estate agent to sell it. If you inherit stocks, you'll have to pay a brokerage commission when you sell them. Your cost basis is the value of the assets on the day the owner died, so you might owe some capital gains tax if the assets sell for a higher price. If there are any estate taxes due, they will be paid by the executor before the property passes to you.

If you inherit an annuity or a tax-deferred IRA, you'll have to pay taxes on distributions, just as the owner would have. Inherited IRAs require special handling to avoid missteps that can result in large tax bills. If you cash out a parent's IRA, say, and roll the money over to your own IRA, the entire amount will subject to ordinary income tax. Another problem will arise if a spouse rolls over the IRA to his or her own IRA. If the surviving spouse is under 59½, distributions will be subject to a 10 percent early-withdrawal penalty in addition to ordinary income tax. The 10 percent penalty will not apply if the IRA is left in the deceased spouse's name.

If you're older than 59½ when you inherit an IRA from a spouse, you can roll it over into an account in your own name, continue the tax deferral, and put off withdrawals until you're 70½, at which time you'll need to start required minimum distributions based on your life expectancy. If the IRA passes to you from someone other than a spouse, you'll need to do a trustee-to-trustee rollover and establish the inherited IRA retitled with the decedent's name and yours as beneficiary. Then you can name a new beneficiary and stretch out the distributions over your life expectancy.

9. Indulge yourself—a little.

Once you've handled the first eight steps, feel free to buy yourself something nice or take a vacation. But limit your indulgence to no more than 10 percent of the inheritance. Be careful about sampling the luxury lifestyle too much—luxuries can quickly become necessities.

This article appeared in Consumer Reports Money Adviser.

Posted: February 2011 — Consumer Reports Money Adviser issue: February 2011