A pseudonymous reader – “Felicia” – wrote in:
Hi Jesse – my husband and I just received a $600K inheritance.
We earn modest incomes and live modestly and don’t know what to do or how to best handle this money.
We still have about $40K of student debt. Those payments are paused, but once it kicks back in the interest rates are ~5%. That’s our only debt.
We rent an apartment and would like to buy a house. Our ideal home would cost $500K in our city. We already have ~$50K set aside for that.
We contribute to our 401(k) accounts and our Roth IRA accounts, but have never earned enough to be able to max them out.
We’re at a loss in a few areas…
- We don’t know what we don’t know. What are some big things we’re likely missing?
- Taxes. Do I need to be worried about taxes this year? In future years?
- Spending. This money seems like our “big chance.” We’re petrified of spending it and ruining our future. But we don’t want to die on a pile of unspent cash.
- Investing. Should my investing strategy change?
Let’s start with the tax surrounding inheritances.
Inheritance taxes get charged to the recipient of an inheritance, like Felicia. Thankfully, there is no Federal inheritance tax. Six states (Nebraska, Iowa, Kentucky, Pennsylvania, New Jersey, and Maryland) charge an inheritance tax.
Estate taxes get charged to the estate of the deceased, prior to money being distributed to inheritors. Felicia already dodged this. There is a Federal estate tax, but it kicks in above $12.92M in assets (for individuals) or above $25.84M (for couples) [as of 2023 IRS tax code]. Some states have estate taxes as well.
Capital gains taxes generally do not apply to inheritances at the time they are given. But if the assets in your inheritance (e.g. stocks) appreciate in value, you will owe taxes on the capital gains if/when you sell them.
Income taxes generally do not apply either, except in one common case: an inherited 401(k) or IRA. The deceased never paid income taxes on any of their Traditional retirement contributions, so the IRS mandates that the inheritor pay income taxes from their inherited IRA. As of this writing, the tax code stipulated that all assets in an inherited IRA must be withdrawn within 10 years of the decedent’s death – with appropriate income tax paid by the inheritor at each withdrawal.
Felicia’s concern over spending is the epitome of personal finance. $600,000 is a lot of money no matter who you are, but especially so if you’ve come from a modest background. Felicia’s right to see this inheritance as a big financial opportunity.
But I hope to dispel her feeling “petrified.”
This inheritance is an opportunity for good. For flexibility. For choice. For fun. Just ask yourself: would you rather have $600,000 or zero? The fact that we all have the same answer suggests that Felicia’s inheritance is positive.
So where do the negative feelings come from?
It sounds like part of Felicia’s fear is the (potential) future regret if she and her husband somehow screwed up this scenario. They never thought they’d get lucky like this. What if they don’t seize their opportunity? What if they let themselves and their family down?
This is why financial planning matters.
Felicia and her husband need to build a plan for their assets. The financial order of operations is a great starting place. Based on her situation, that plan should probably include:
- A small amount for immediate pleasurable use. There’s no hard rule, but something in the ballpark of 5% or $10,000 feels right. Go take that trip you’ve been wishing for!
- Debt payoff. I would recommend Felicia immediately pay off her $40,000 student debt (once payments start again – no sense paying off the loans while payments and interest are deferred). It will ease her burden (she cares about it enough to mention it in her question) and the payoff is equivalent to a 5% return on those assets. This does not mean debt payoff should be part of all inheritance scenarios. But in this case, I think it’s smart advice.
- Earmarking for a home purchase. 20% is a typical down payment. That’d be $100K for a $500K home. More is better. And there are those pesky closing costs. If Felicia’s home purchase timeline is “ASAP,” I’d recommend Felicia set aside $100K of this inheritance into a high-yield savings account for this specific purpose.
- “Endowed” spending. Felicia mentioned the desire to avoid “dying on a pile of unspent cash.” I think it makes sense for her to pre-plan a small percentage of spending every year. Something in the 1-2% range, or $6K – $12K, feels about right. Let’s pick a number: $9000 per year. Felicia could spend it on fun, or on making many small facets of life a little bit better. To accomplish this spending, Felicia should set aside a chunk of money today – say, $150K – into a conservative, diversified portfolio for the specific purpose of annual, purposeful spending. We’ll talk about this again in the Investing section below.
If you’re keeping track, we’ve earmarked $300,000 of Felicia’s $600,000 inheritance.
- $10,000 for a fun trip right away.
- $40,000 to pay off college debt.
- $100,000 for a home downpayment.
- $150,000 for ongoing “endowed” spending.
What to do with the remaining $300,000?
The remainder of Felicia’s inheritance should be invested for the long haul. But other portions of her Spending assets should probably be invested too.
Her specific investing allocation depends on the unique goals and timelines of the assets.
- Home Purchase: We already covered that $100K should be “invested” (really it’s deposited) into a high-yield savings account, earmarked for Felicia’s home purchase. It’s cash, earning ~4% in today’s interest rate environment, and insured by the FDIC.
- “Endowed” spending. If Felicia sets aside $150K for annual, purposeful spending of $9000 per year, that $150K should be invested. Why?
- While some of that $150K is short-term (e.g. the $9000 spent this year), much of it is long-term.
- If we think of the $150K as a true endowment (like a university), the $150K principal itself should be left alone as much as possible.
- Something like a 50% stock, 50% bond portfolio allocation for this $150K combines Felicia’s needs for short-term capital and conservative long-term growth.
- Long-term money. The remaining $300K should be invested for the long run. Depending on Felicia’s specific risk tolerance, a stock allocation of 70-100% is appropriate, with the remaining assets in bonds and (if she’s seeking further diversification) a small sleeve of alternatives. For now, let’s just say she invests these $300K at 80% stocks, 20% bonds.
We can add these buckets up to see that Felicia’s total portfolio is:
- 25% Cash: $100K, plus the original $50K she had earmarked for a home purchase.
- 25% Bonds: $90K in her “Endowed” bucket, plus $60K in her “Long-Term” bucket.
- 50% Stocks: $60K in her “Endowed” bucket, plus $240K in her “Long-Term” bucket
This might be a big change from Felicia’s prior investing allocation. But our logical investing framework should work for everyone at any crossroads in their life:
- Identify your goals.
- Apply dollar amounts to them.
- Determine timelines to reach those goals.
- Invest appropriately. Shorter timelines demand lower-risk assets, and vice versa.
This is the famous “bucket your money” method.
What else? Did Felicia miss anything?
Felicia and her husband should certainly start maxing out their Roth IRA every year. If nothing else, they should pull $13,000 from their “Long-Term” taxable brokerage and deposit that money into their Roth IRAs.
Should they max out their 401(k)? They certainly should get the match – it’s free money! But beyond that free money, they should weigh the benefits of the 401(k) tax advantage against the cost of locking up money until age 59.5. This article breaks down that important 401(k) math.
Now that Felicia & Family have some assets, they should revisit their estate plan (if they had one in the first place). Talking with an estate planning attorney and a CFP financial planner is a great start.
Finally, Felicia seems to be doing a good job doing her “homework.” You don’t want to rush these kinds of decisions, but you also don’t want to delay too long. Take your time, do your research, but then execute a plan.
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