When a beneficiary receives an inheritance, it may be an emotional time, making it difficult to know what to do with the inheritance. However, knowing the options available to manage that inheritance and any potential tax implications can help in navigating the process. Before deciding what to do, there are some considerations to take into account.
What can you do with a cash inheritance?
Determining what to do with inheritance money depends on your finances and life circumstances. A beneficiary struggling with debt may get some breathing room in their finances. Another with children may be able to save for college. There are numerous options to consider when inheriting money. Knowing your financial goals can help when making the decision: “What should I do with my inheritance?”
1. Pay off debt
A beneficiary with high-interest debt like credit cards may want to consider paying off debt with a cash inheritance. With the average credit card interest rate currently at 20.2%, according to Bloomberg, this can lead to significant savings and wiping out debt can provide peace of mind and free up room in one’s budget.
2. Pad your emergency fund
Most experts agree that having enough in a savings account to cover six months of expenses is a good start for an emergency fund. A cash inheritance can be the beginning of an emergency fund or help in reaching that goal.
3. Save for retirement
A cash inheritance can help provide a nice nest egg for a beneficiary’s retirement. Using the funds to max out retirement accounts, such as a Roth IRA or a 401(k), can help set up a solid financial future. The max amount that can be contributed to an IRA is $6,000 if younger than age 50; $7,000 if 50 or older. The contribution limit for a 401(k) is $20,500 for under age 50 or $27,000 for age 50 or older. Receiving a large inheritance can free up room in a person’s budget to make additional retirement contributions to max out their accounts.
Investing inheritance money allows the beneficiary a chance to build funds for their future. Investing options can include individual stocks, ETFs or index funds, mutual funds, cryptocurrency, and real estate. A beneficiary may also consider engaging an investment advisor for help.
5. Save for your children’s future
A parent who receives a cash inheritance may want to save for a child’s future expenses, including college tuition. Opening a 529 college savings plan helps a parent save for future tuition costs and fees, housing expenses, books and supplies, meal plans, among other qualifying expenses for a child to attend college or vocational training.
6. Secure housing
Using an inheritance to pay off a mortgage, save for a down payment, or purchase a home can help decrease housing expenses, which have been on the rise. Having housing secured can give freedom to pursue other dreams and goals.
7. Remember your loved one
Receiving an inheritance can be bittersweet. Using the funds to remember a loved one may help the grieving process. Take a trip that reminds you of your loved one, name a scholarship in their honor, attend their favorite sporting event, or have a tree planted in their memory.
Inheriting other assets: what to do
There are other assets that beneficiaries can inherit besides cash. These include real estate, valuables, and collectibles. It may be confusing to know what to do with this inheritance and the tax consequences of inheriting them.
What to do if inheriting a house
A beneficiary who inherits a house has three main options:
- Sell. Selling to receive the cash is an option. However, there are potential tax consequences. The beneficiary may end up owing capital gains taxes. For example, if at the time of the deceased’s death the house is valued at $300,000 and the beneficiary later sells it for $320,000, capital gains taxes would be owed on the $20,000 gain, which is the difference between the sale price and the so-called “step up in basis,” or the adjusted property value at the time of a person’s death.
- Rent. Any rental income an heir receives must be included as income on their federal, and if applicable, state tax return. This potentially will cause more income taxes to be due because rental income is considered ordinary income on a person’s federal return.
- Move in. Using an inherited property as a primary residence has no tax implications.
What to do if inheriting valuables or collectibles
When inheriting coins, antiques, artwork, stamps, and other valuables and collectibles, a beneficiary has the option to keep or sell the items. In many circumstances, if the beneficiary keeps the collectibles, taxes will not be due unless the location of the estate warrants an inheritance tax. Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania are the only states that levy an inheritance tax. The tax rates range from 1% to 18%.
If the beneficiary decides to sell an item, capital gains taxes may be due on any increased value of the item. An appraisal can establish the fair market value and compare it later to the selling price.
Paying taxes on an inheritance
Receiving an inheritance can help financially, but there are potential tax consequences. These can include:
- Inheritance tax. There is no federal inheritance tax but some states impose one. This tax applies to estates in six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. If a beneficiary receives an inheritance from an estate in one of those places, they may owe a percentage of that inheritance to the state. There are exemptions for estates under a certain monetary threshold and for close family members, like a spouse.
- Estate tax. An estate tax applies in 12 states and the District of Columbia. The federal government also imposes taxes on estates valued at more than $12.06 million in 2022. This tax is the responsibility of the estate to pay. That means the executor overseeing the estate pays it out of the estate’s value. Although the beneficiary is not responsible for this tax, it reduces the value of the inherited estate.
- Income tax. Income taxes will be due by the beneficiary if the inherited asset produces income. This can apply when interest, dividends, or rental income is received. For example, suppose a cash inheritance earns interest in a bank account. The interest will count as income and would be included on the beneficiary’s Form 1040 before tax return. Income tax will not be due on the inherited amount but on the interest earned. Any rent received from a rental property would also be counted as income and taxed.
- Capital gains tax. The capital gains tax may be applicable if a beneficiary sells an asset. When selling inherited stock, real property, or collectibles and valuables that have increased in value since the date of the deceased’s death, taxes will be owed on the difference of the increased value.
Considerations if you receive an inheritance
It may not be obvious what to do with the inheritance right away. Fortunately, there are some ways to simplify the decision-making process:
- Seek professional advice. A financial advisor, lawyer, or appraiser may be among the professionals to consider hiring when receiving an inheritance. They can provide advice on how to best proceed with the inheritance and any potential tax consequences.
- Take your time. With a cash inheritance, decisions do not have to be made immediately. Consider putting the money in a savings account that pays interest while deciding the best course of action.
- Think about the future. Planning financial goals and setting a budget can help an heir decide how to use certain assets.
- Consider tax consequences. Some assets and actions may require paying taxes, such as income tax or capital gains tax. Seek a tax professional to help understand the different taxes that may apply.
- Understand any restrictions. Receiving an inheritance can come with restrictions. For example, a will may limit the inheritance, allowing it to be used only for educational purposes or be accessible after a certain age.
The bottom line
A cash inheritance can help provide financial security, but immediate decisions aren’t always necessary. Inheriting other assets such as real estate or valuables can present options of whether to keep or sell an inherited asset. However, selling can result in a tax liability. Professional resources available to beneficiaries of an inheritance include a lawyer or financial advisor.