A reader recently asked me about dealing with an inheritance, so I will be addressing those issues in this article.

It may be likely that you will receive an inheritance at some point in your lifetime, most often from a parent. It’s important to realize and respect that along with the money, an inheritance often carries a variety of emotional reactions.

I often hear clients speak of the burden of the inheritance and the strong wish to use the money in a prudent manner. Some want to make sure a portion of the money continues to be passed down in the family. Many remember the effort required to accumulate the money and want to be good stewards of it. Since the money may significantly alter your current and future living conditions, the emotions can be mixed and varied.

Some people are concerned about the tax implications but the taxes have generally already been paid by the estate. You may receive the inheritance in cash and/or investments. In the case of investments your only tax obligation is on the growth of the amount you invest. In other words, if you inherit a stock or mutual fund, the tax clock begins again on the date of death and you pay taxes only on the gain from the date of death to the date you sell the asset unless the inheritance comes in the form of a retirement plan.

If the investment you inherited is an IRA or a 401K, the laws are specific. You essentially have three options:

1. you may roll over the money into an inherited IRA and then take a distribution immediately or by December 31st of the year following the death.
2. After you have transferred the money into an inherited IRA, you may take your distribution in cash. That amount would be included in your gross income for that year.
3. You may also disclaim the inheritance within nine months so that the money can be distributed to the other beneficiaries.

The tax laws can be tricky and the decision far reaching, so be sure to check with your tax professional as part of your planning.

If you live in a community property state, you have the option of keeping the inheritance as separate property from your spouse. If you choose to do that, open a separate account for this so it’s not co-mingled with any of the family finances.

The general rule of thumb is not to make any major decisions immediately. When a major change occurs in our life we are often tempted to “get things handled” so life can go back to the way we know it. Some studies have shown that people who receive an inheritance or win the lottery often revert to the previous habits and lifestyle that they had before receiving the money within three years. This may not be appropriate. Instead, put the money into a money market fund or certificate of deposit so there’s time to process the emotions and explore different ways you may use and/or invest the money. Even though interest rates are low and/or the investment you inherited might not be the most appropriate for you, it’s better to give yourself plenty of time instead of moving too quickly and regretting it later.

Take at least six months, but preferably a year, to consider various options. Perhaps the person leaving you the money had a special picture of how the money would be used. If not, you might choose to allocate the money to several different categories. For example, a portion of the money might be allocated to pass on to your children, a portion to use now to pay down any debt or to purchase an item you have longed for and a portion to be invested for the future.

Paying off any debt should be a high priority. If there’s no debt you may want to increase the amount you save for retirement. One way to do that might to increase the investment in your retirement account to the maximum if you aren’t already saving that amount. Increasing your savings would result in a lower take-home amount but that difference could be funded by the inheritance.

For example, let’s say that you wanted to increase your 401K contribution by $500 a month. Depending on your tax bracket, your take-home pay would be reduced by $350. You could put $5,000 of the inheritance in a bank account and then use $350 of it every month to replace the reduced amount of your take-home pay. That strategy would increase your tax-deferred savings.

It also makes sense to use part of the inheritance for something now in the form of something you’ve always wanted.

When my favorite aunt passed away a few years ago, we were very surprised to receive a small inheritance. It came at a time when we had almost saved enough money for a new car. Using a portion of the inheritance allowed us to get a car sooner. Every time I drove the car, I mentally thanked my aunt for her life and her generosity.

Making a donation in the memory of the deceased is also a wonderful way to carry their memory.

Lots of options and challenges exist for any new money that you may receive. Take ample time to explore the options that are best for you in your situation.

I’m very interested in hearing how this works out for you. Please let me know.

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